On May 12, the US Bureau of Labor Statistics (BLS) reported that April CPI rose 3.8% year-on-year, the highest level in nearly three years and above March’s 3.3% reading. Energy prices increased 17.9% year-on-year, gasoline rose 28.4%, and airfares climbed 20.7%. The May inflation report will be released on June 10, with markets expecting CPI to accelerate further toward 4.2%.

However, we believe the primary source of inflation is the energy shock triggered by the Iran conflict rather than overheating demand. Using policy rates to combat the price transmission effects of an oil war would itself constitute a policy mistake.

Four Structural Reasons Why the Fed Is Likely to Stay on Hold

1. Interest Rates Are Already in the Neutral Zone

The federal funds target range currently stands at 3.50%–3.75%.

Minutes from the April FOMC meeting revealed that “almost all participants” believed the current policy rate was “within the reasonable range of estimates of the neutral rate.”

The neutral rate is the level of interest rates that neither stimulates nor restricts economic growth.

When rates are already near neutral, there is neither an urgent need to cut rates nor a compelling justification to raise them.

2. The Labor Market Remains Strong, But Structural Weaknesses Are Emerging

On June 5, the BLS reported that non-farm payrolls increased by 172,000 in May, significantly exceeding market expectations of 80,000–85,000. The unemployment rate remained at 4.3%.

Average hourly earnings rose 0.3% month-on-month and 3.4% year-on-year, both in line with expectations.

On the surface, the labor market appears healthy and in no need of support.

However, TD Economics offered an important interpretation.

Average payroll growth over the past three months has been 188,000, well above the six-month average of 92,000 and the twelve-month average of 42,000.

Such a sharp rebound may partly reflect statistical noise.

Meanwhile, the number of long-term unemployed workers (27 weeks or more) has increased by 524,000 year-on-year, while the labor force participation rate remains at 61.8%.

These figures suggest that labor market improvements remain uneven.

Employment data is neither strong enough to justify rate hikes nor weak enough to demand rate cuts.

3. The Bond Market Has Already Tightened Financial Conditions

The 10-year Treasury yield stood at 4.57% on June 8, while the May monthly average was 4.48%, according to Federal Reserve Bank of St. Louis FRED data.

Compared with the upper bound of the federal funds target range at 3.75%, long-term yields have already moved substantially higher.

In practice, financial conditions have tightened naturally.

The Federal Reserve does not need to use policy rates to achieve this outcome because the market has already done part of the work.

With the 10-year/2-year Treasury spread still positive at 41 basis points and the yield curve maintaining a relatively normal shape, any additional policy tightening carries a genuine risk of overtightening.

4. The “First Meeting Effect” of a New Fed Chair

Any significant action taken by a newly appointed Federal Reserve Chair during their first FOMC meeting would likely be interpreted by markets as a statement of policy philosophy rather than a response to economic data.

Warsh needs time to build consensus within the Committee.

The April meeting produced four dissenting votes, the highest number since 1992.

Three regional Fed presidents opposed language maintaining a bias toward future rate cuts, while one member, Milan, voted in favor of an immediate 25-basis-point rate cut.

The depth of disagreement within the Committee remains significant, and even Warsh’s first meeting has yet to establish a clear internal consensus.

The Market’s “Rate Hike Probability” May Be an Illusion

A narrative is currently gaining traction in financial markets: if May CPI continues rising, the Federal Reserve could be forced to raise rates.

Following the strong May employment report, the 10-year Treasury yield climbed to 4.57% on June 8.

Markets are now pricing in nearly a 70% probability of at least one rate hike before year-end.

However, rate hikes require more than simply elevated inflation.

They require broad-based and persistent increases across core inflation categories, along with consensus among the majority of FOMC members.

At present, core CPI is running at 2.8% year-on-year, while core goods prices were unchanged on a monthly basis.

More fundamentally, oil prices jumped more than 4% on June 8, rising above US$94 per barrel, directly due to renewed missile exchanges between Iran and Israel that threatened a fragile ceasefire.

This type of geopolitically driven price volatility is unlikely to trigger a meaningful policy response from the Federal Reserve.