By Greg Ip
Officially, the Federal Reserve is still focused on when and by how much to cut interest rates again.
Unofficially, the vibes have changed. The Fed's next move might be to raise rates.
Emphasis on "might." This isn't the Fed's or my personal baseline scenario. But three factors are raising the risk.
First, inflation remains stubbornly above the Fed's 2% target. Second, the jump in oil prices could push it farther from the target without slowing demand much. Third, interest rates are down a lot since the Fed started to ease in 2024 and by some measures are going lower.
At its recent meeting, the Fed affirmed it remains in rate-cutting mode. Officials penciled in a quarter-point cut this year, and another next year. But at his press conference, Chair Jerome Powell said that was conditional on inflation falling.
Similar caution prevails globally. Australia's central bank raised rates, Japan's said hikes were coming, Britain's said a hike was more likely than a cut, and Canada's and Europe's suggested either a hike or cut might be in order.
Markets reflect the shift in vibes. Globally, government bond yields have risen on expectations of more-hawkish central banks. In the U.S., markets have lowered the probability of a Fed cut this year to 37% from 72% at the end of 2025, while raising the probability of an increase to 45% from 11%, according to the Atlanta Fed.
Stubborn inflation
A one-off rise in prices -- for example, because of oil or tariffs -- causes lasting inflation only if it works its way into other prices and wages. The Fed failed to contain those "second round" effects in the 1970s. But after it broke inflation's back in the 1980s, the public came to expect low inflation to prevail, limiting second-round effects.
This experience has guided the Fed's easing since mid-2024. As long as inflation expectations stayed anchored around its 2% target and the labor market wasn't tight, it believed inflation would drift back to 2%.
It hasn't. True, inflation as measured by the consumer-price index was only 2.4% in February. But the Fed targets the more-comprehensive price index of personal-consumption expenditures. It showed inflation at 2.8% in January and core inflation, which excludes food and energy, at 3.1%, both little changed from late 2024.
The Fed has blamed this on such idiosyncratic factors as tariffs on goods and lags between housing data and rents. To tease out the underlying trend, the Fed has focused on core services prices excluding housing.
But like overall inflation, this measure hasn't budged in a year. At 3.5%, it's well above its prepandemic pace. "It's frustrating," Powell acknowledged to my colleague Nick Timiraos on Wednesday.
James Egelhof, chief U.S. economist at BNP Paribas, said this undercuts the Fed's strategy. "If you've been running monetary policy on the assumption that inflation expectations would naturally bring inflation down, well, it hasn't," he said. "That suggests something is not working as expected."
If the Fed can't rely on expectations to bring down inflation, it will have to rely on a weak economy and job market, and that means raising interest rates.
The two-way risk from oil
Ordinarily, the Fed would be content to look past the temporary boost to inflation from higher oil and focus on its damage to incomes and spending.
That damage argues against a rate increase by curtailing any second-round effects on prices and wages. If bad enough, the Fed would likely cut rates.
But the damage so far looks limited. Even if gasoline tops $4 a gallon in coming days, that is a third less, adjusted for inflation, than in 2008, when oil hit records. And Americans consume less gasoline than back then while producing 42% more goods and services. The U.S. is also now a net exporter of petroleum and a major exporter of liquefied natural gas, so it benefits to some extent from higher prices.
Meanwhile, the Trump administration has pulled out the stops to run the economy hot ahead of November's midterm election. Last year's Republican megabill will inject an estimated $200 billion into the economy through lower taxes and refunds. The Pentagon plans to ask Congress for $200 billion more to fight Iran. The Fed is about to lower banks' capital requirements, which will stoke lending and dealmaking.
All of this explains why Fed officials and private economists have largely left growth and unemployment forecasts unchanged since the war started. The corollary is that this provides no buffer against inflation pressure.
Rates aren't that high
The Fed had good reason to start cutting rates in September 2024. Its rate target, at between 5.25% and 5.5%, was quite high, as unemployment had risen and inflation had fallen. It paused cuts last year when tariffs threatened to push inflation higher, then resumed as the job market weakened.
So monetary policy today is much less restrictive. The Fed's current target, at 3.5% to 3.75%, is only marginally above Fed officials' revised 3.1% estimate of "neutral," which neither holds back nor stimulates spending.
Moreover, it is real rates -- i.e., nominal rates adjusted for inflation -- that matter for the economy. Keeping rates unchanged while inflation rises means real rates fall, making monetary policy even easier, notes William English, a former top Fed staffer who is now at Yale University. The real 2-year Treasury yield has fallen this year, even as the nominal yield has risen. If the inflation surge lasts, "that becomes a real issue," and would justify a rate hike, he said.
Given all that, why isn't a rate hike the baseline scenario? One reason is that as tariffs and housing pressures recede, odds are that inflation will resume its decline. Another is the labor market. Though not in dire straits, it isn't exactly healthy, either. Wages are growing less than 4% a year, which, coupled with solid productivity growth, is easily compatible with 2% inflation.
Finally, as the war with Iran drags on, the risk grows of energy prices going higher for long enough to damage the economy seriously and disrupt financial markets, perhaps even causing a recession, which would ultimately push inflation down. That counsels patience before anyone at the Fed seriously thinks about raising rates.
Write to Greg Ip at greg.ip@wsj.com
(END) Dow Jones Newswires
March 21, 2026 05:30 ET (09:30 GMT)
Copyright (c) 2026 Dow Jones & Company, Inc.
