Warsh faces first big test as Fed hawks push to reverse 2025 rate cuts

Internal pressure is building on Fed Chair Kevin Warsh to raise rates at the July 28-29 meeting, potentially reversing last year's three cuts.

Federal Reserve officials are facing growing internal tension over whether to raise interest rates as the labor market stabilizes and inflation remains lodged above the 2 percent target, according to people familiar with the discussions. Warsh, who presided over a unanimous decision to hold rates steady at his first meeting as chairman in June, now confronts a bloc of hawkish colleagues who argue that last year's three rate cuts — delivered when the labor market appeared to be faltering — should be partially undone.

"The risks have completely flipped," Fed Governor Christopher Waller, who led the case for last year's reductions, said last week, declaring that his sense of where rates should go had shifted. Waller's about-face captures the broader realignment on the Federal Open Market Committee: the labor-market slump that drove the 2025 easing cycle never materialized, while inflation has run between 3 percent and 4 percent — well above the Fed's 2 percent goal. The fed funds rate currently stands at 3.50 percent to 3.75 percent, which in real terms is close to zero or negative, meaning monetary policy is stimulating the economy more than the central bank intended.

The June consumer-price index report, due Tuesday, could tilt the debate. Economists surveyed by Barclays expect headline inflation to moderate to 3.8 percent from 4.2 percent in May, reflecting the dip in crude oil prices after the US-Iran peace deal was signed in mid-June. A soft reading on core inflation — which excludes volatile food and energy items — would strengthen the case for patience. Firm readings would hand the hawks evidence that price pressures require a response. Warsh is scheduled to testify before the House Financial Services Committee on Tuesday and the Senate Banking Committee on Wednesday, his first appearance on monetary policy since his confirmation, offering markets a window into his thinking.

The Inflation Puzzle

The Fed faces an unusually complex inflation environment. Unlike prior episodes where the labor market drove price pressures, today's inflation stems from a series of idiosyncratic shocks: tariffs on imported goods, energy and fertilizer disruptions from the Iran war, and — increasingly — the artificial-intelligence build-out. "Most of the analytical tools that we have to try to analyze inflation start in the labor market. Yet the labor market is not causing the inflation," Minneapolis Fed President Neel Kashkari said at a panel last month. "That makes it a particularly challenging moment for us."

New York Fed President John Williams, the rate-setting committee's vice chair, has counseled patience, saying interest rates are "well positioned" and tying that view to inflation cooling over the second half of the year. He said he is looking for monthly core inflation readings of 0.2 percent or lower as tariff effects wane — a pace that, annualized, runs near the Fed's 2 percent goal. "If things play out in a more benign way, I do think that monetary policy would continue to be well-positioned," Williams said last week. But he warned that faster readings would signal more persistent inflation: "Monetary policy would need to respond to that."

The prices of semiconductors and electrical gear, which usually inch along, now look like "hockey sticks" on a chart, Williams noted, driven by the hundreds of billions of dollars flowing into data-center construction. Unlike tariff- or oil-driven price shocks — which central banks typically "look through" — AI-driven demand is a continuing source of economic stimulus that interest rates can restrain.

What a Hike Would Mean

Advocates for a rate increase argue for a modest correction rather than a full-fledged hiking campaign: take back insurance that is no longer needed, then stop and reassess. "It's simply reflecting welcome, positive news from the labor market and some issues with inflation that need to be taken into account," said James Egelhof, chief US economist at BNP Paribas, who expects the Fed to raise rates three times beginning no later than December.

The two-year US Treasury yield has already climbed to a 16-month high, reflecting market expectations of tighter policy. Current pricing suggests a 16 percent probability of a 25-basis-point hike at the October 2026 meeting, up from 14 percent a day ago, according to prediction-market data. A rate increase at the July meeting would mark a dramatic pivot from the easing cycle that defined 2025 and would represent Warsh's first major policy signal since taking the helm.

The last time the Fed reversed course this quickly was in 2022, when it shifted from pandemic-era accommodation to the most aggressive hiking campaign in four decades. While today's circumstances are less extreme — inflation is running at roughly half the 2022 peak — the political and market stakes are similar. Warsh could side with the doves and hold steady, risking dissents from hawkish colleagues, or propose a hike to reinforce his commitment to price stability. His testimony this week, delivered with fresh inflation data in hand, will offer the first real clue.

This article is for informational purposes only and does not constitute investment advice.