The Federal Reserve's Kashkari reiterates "hawkish" stance: Inflation cannot become the new norm, rate hikes still possible

The rapidly escalating situation in the Middle East is putting the Federal Reserve in a policy dilemma. Minneapolis Fed President Kashkari publicly stated on May 8 at an event in Marquette, Michigan that he "really doesn't know what the future holds" in light of the uncertainty brought by the Iran war, and explicitly warned that "if the Strait of Hormuz remains closed for a long time, the next step may likely be to raise interest rates." On the same day Kashkari made the above statement, explosions were reported in the vicinity of Sirik in Hormozgan Province and near the port of Abbas in Iran, and the US military confirmed the so-called "targeted strikes" on military facilities in the ports of Qeshm and Abbas. Iran claimed to have retaliated against three US destroyers causing "significant losses." Brent crude futures surged over 2% after the news came out, surpassing $100 per barrel once again, while US stocks turned from gains to losses, with all three major indices closing down. Kashkari's remarks are not just his personal stance but the latest evidence of serious divisions within the Federal Reserve surrounding the Hormuz crisis. At the Federal Open Market Committee meeting that ended on April 30, the federal funds rate target range was kept unchanged at 3.5% to 3.75%, but there were rare four dissenting votes, marking the highest number of dissents since 1992. Kashkari, Cleveland Fed President Hamek, and Dallas Fed President Logan all supported the decision to keep rates unchanged, but the joint dissenting policy statement hinted at a more dovish tone suggesting a possible rate cut in the next step. Meanwhile, member Milan continued to vote against, advocating for an immediate rate cut of 25 basis points. "We voted against forward guidance because we do not want to send a signal that the next action may be a rate cut," Kashkari explained his dissenting vote in his speech on Thursday. The consensus of the three hawks: "Accommodative stance is no longer appropriate," "Rate hike option" on the negotiation table The policy statement from the April meeting contained a highly directional hint: "As the Committee considers further adjustments to the federal funds rate target range in both magnitude and timing, it will assess carefully the latest data, evolving outlook, and balance of risks." Observers of the Fed widely believe that the term "further adjustments" implies that the next rate move will continue the previous trend of rate cuts. This term has become the focal point of hawkish collective "vote of no confidence." Kashkari's logic in his post-meeting remarks is that even in the most optimistic scenario - the swift reopening of the Strait of Hormuz and the resumption of global commodity flow, core inflation in the US is likely to remain at a level of 3% this year. This is well above the Fed's target of 2% and is enough reason to keep rates unchanged, let alone to continue to hint at a rate cut. "If the forecast comes true, core inflation would hover around 3% for three consecutive years, such a level of inflation shock could pose a substantial risk to inflation expectations and may require a series of rate hikes to defend the Fed's credibility on the 2% target." Cleveland Fed President Hamek's statement was more direct. She pointed out that the Iran war and the subsequent surge in oil prices pose a clear threat to the Fed's 2% inflation target, and inflationary pressures "remain widespread." In her view, "given the current outlook, this clear accommodative stance is no longer appropriate." The unanimous stance of the three hawkish voters signals an open rift within the Fed in the face of the Hormuz crisis. On a deeper level, Kashkari's remarks formally introduce the "rate hike" option into the Fed's policy narrative. He explicitly stated at the aforementioned meeting that significant price shocks may require a series of rate hikes to maintain the central bank's credibility in defending its inflation target: his previous speeches outlined three scenarios more systematically: in the extreme case of "long-term closure of the strait", a rate hike would be necessary; in the benchmark scenario of "rapid reopening of the strait", rates only need to remain unchanged for a longer period; and between these two, there are a series of unpredictable geopolitical variables. Hormuz standoff: From the failure of the "Freedom Plan" to the resurgence of hostilities Understanding the root cause of the rift within the Fed must go back to the continued quasi-closure of the Strait of Hormuz since late February. Since the US and Israel's joint attacks on Iran at the end of February, Iran has completely blocked the Strait of Hormuz, interrupting about 20% of global oil and gas shipments. Global oil supply has decreased by up to 14 million barrels per day. Brent crude futures have risen by over $30 per barrel since February 27, and actual market prices for some non-Middle Eastern crude oil, such as Norway's Sverdrup crude, have soared to $150 per barrel. The US had attempted to forcibly break the deadlock with the "Freedom Plan." On May 4, the US military launched this operation, intending to "escort" stranded merchant ships through the strait. However, the plan lasted less than 48 hours before being suspended. During this time, both the US and Iran exchanged fire: Iran claimed to have repelled US destroyers with warning shots, while the US admitted Iran had launched multiple cruise missiles and drones. Multiple vessels from various countries were attacked, including oil company ships from the UAE and British oil tankers. On May 5, US President Trump announced the suspension of the "Freedom Plan," claiming it was to see "whether an agreement with Iran can finally be reached and signed." Analysts widely believe that the plan was, in essence, a US attempt to test Iran's response, but it was met with a strong counter from Iran. Iran's top foreign affairs advisor, Velayati, declared on the same day that the Strait of Hormuz was closed and would not reopen unless the "national will of the Islamic Republic of Iran decides"; and that Iran and the US were still in a state of war. Just two days earlier, Trump had said it was "very likely" an agreement with Iran would be reached. However, from May 7th to 8th, the situation suddenly escalated. The US conducted targeted strikes on Qeshm Port and Abbas Port in Iran. Trump later described the operation as "just a gentle tap" in an interview and insisted that the "ceasefire is still in effect and remains valid," denying that the strikes meant the end of the ceasefire. "Inflation cannot become the new norm" In the complex game of the Middle East geopolitical storm and the central bank policy dilemma, Kashkari's warning points to a more fundamental proposition: the US has seen inflation rates higher than the Fed's target for five consecutive years, and the Fed's credibility is facing an unprecedented test. "We cannot let high inflation become the new norm," Kashkari emphasized in his remarks on Thursday. He further pointed out in a previous article that even if raising rates to curb inflation could raise unemployment, he still "firmly believes that anchoring long-term inflation expectations is necessary to achieve maximum employment and a vibrant economy." This statement fundamentally places defending the inflation target at the forefront of the Fed's dual mandate, with the underlying assumption of its policy logic being: once inflation expectations become unanchored, achieving both price stability and full employment becomes an impossible task. For Kevin Walsh, the incoming Fed Chairman, this undoubtedly poses his first major test after taking office. Lawrence Gillum, chief fixed income strategist at LPL Financial, stated, "There is no doubt that the road ahead for Walsh will be full of challenges," which may become a core highlight of the Fed's policy narrative for the remainder of 2026. Rate market bets quietly shifting In the face of the uncertainty described above, Wall Street's rate expectations are undergoing subtle and far-reaching changes. The latest pricing of swaps contracts tied to Fed rate decisions shows that traders believe the probability of a rate hike by the Fed before April next year has exceeded 50%, while expectations for rate cuts have been pushed back to early 2028. Analysts at Evercore ISI wrote in a recent report: "The stabilization of the labor market will enable the Fed to focus firmly on addressing the inflationary shocks caused by oil prices until inflation is under control, and only then will they reconsider rate cuts." Meanwhile, the 30-year US Treasury yield has surpassed the 5% mark for the first time this year, prompting Brij Khurana, a portfolio manager at Wellington Management Company, to say, "The US market is still unwilling to accept the possibility of a rate hike cycle, which is shocking." However, there is dissent within the Fed's higher ranks over rate hikes. William Williams, often referred to as one of the "three hands" of the Fed, tried to soothe the markets in a speech on May 4. On the one hand, he acknowledged high inflation, mixed signals on employment, and high uncertainty brought by the Middle East situation, and on the other hand, he emphasized that in any data he had, "there are no signs of needing a rate hike in the near term." Williams raised this year's inflation expectations to about 3% and predicted that it wouldn't return to 2% until 2027. Williams' statement is interpreted by the market as an attempt to bridge internal divisions and stabilize market expectations after the rare occurrence of four dissenting votes last week. He particularly noted, "Although individual members opposed maintaining an accommodative policy stance, in terms of the overall policy direction as it stands, the consensus formed within the Fed is actually much more than the discord presented by the vote results." It's worth noting that the Fed is currently at a crucial juncture of leadership transition. Current Chairman Powell's term is coming to an end, and Kevin Walsh, nominated by Trump, is set to take over as Fed Chairman on May 15. Trump has repeatedly pressured the Fed to cut rates, and the inflation pressure driven by the Iran conflict is creating a policy barrier that is almost insurmountable before the new Chairman takes office.