The US economy continues to run at full speed, with above-trend growth, inflation above target, and now a recovering labor market. All these factors suggest that the Fed’s monetary policy will take a more “hawkish” stance. Consequently, PGIM has updated its current Fed forecasts, now anticipating three 25 basis point rate hikes this year. These rate hikes will likely be short-lived, and we expect three 25 basis point cuts in 2027, followed by a final cut in 2028, for a terminal rate of 3.375%, slightly below the current benchmark rate level.
US Economy: Expanding
Five key factors have led us to revise our interest rate forecasts:
1. Above-trend US growth: The US economy continues to show remarkable resilience. We forecast real GDP growth of 2.3% this year, extending a series of above-trend results. The US outperformance is driven by the development of artificial intelligence, the wealth effect on consumption, and fiscal stimulus. Above-average tax refunds and a still-low unemployment rate are providing ongoing support to consumers and offsetting the impact of the energy shock. Positive wealth effects from rising financial asset prices, driven by the artificial intelligence ecosystem, continue to fuel spending by high-income households.
2. Elevated inflation with upside risks: US headline PCE inflation rose to 3.8% year-over-year in April, with the latest increase driven by higher energy prices. Core PCE inflation, which excludes food and energy prices, is also at concerning levels, standing at 3.3%. The good news so far—as further highlighted by May’s Consumer Price Index (CPI) data—is that pressures from the conflict with Iran have not yet been reflected in core prices. However, we believe inflation risks are tilted to the upside for several reasons; perhaps the most concerning is that leading indicators of “pipeline” inflationary pressure on consumer prices, such as the Producer Price Index, remain very strong.
3. The US labor market is overheating: The labor market is in a phase halfway between stabilization and acceleration, trending toward the latter. It is surprising that payroll growth has averaged 188,000 per month over the last three months, a sharp increase from the roughly 10,000 per month pace in 2025. Although other labor market indicators, such as wage growth and quit rates, do not yet suggest overheating, we expect these data to lag behind the renewed strength we are seeing in hiring.
4. Fed’s restrictive tone: The shift toward more restrictive Fed communication has been notable in recent weeks, especially as it has continued after Kevin Warsh’s appointment as Fed Chair. A month ago, some Fed officials were still talking about a gradual rate decrease over time, but this type of communication has now almost entirely disappeared. Increasingly, officials are discussing the possibility of rate hikes and, in many cases, are broadening the criteria that could justify such increases.
5. Fed Chair Warsh’s stance: How Kevin Warsh will exercise his role as Fed Chair has been debated for months. Will he maintain his belief that the Fed should raise rates in the presence of supply-side shocks, or will he argue that the underlying inflation trend looks favorable and rates should decline over time? Given the rapid change in conditions on the ground in recent months, we expect he will opt for the former. Even if core inflation data were better than expected, inflation is still far from the Fed’s target, and Warsh may need an initial “Volcker moment” to consolidate his credibility and help bring inflation toward the 2% target. The most important question for us, and the biggest risk to our forecasts, is whether there will be political cover allowing Warsh to raise rates. If rate hikes are presented as a “precautionary” effort to counter supply-side inflation and the recent rise in long-term Treasury yields, we believe there will be.
Market Implications
First, US Treasury yields could face further upward pressure as the Fed initiates a precautionary rate hike cycle. According to our model, regarding US Treasury yields, we estimate that 10-year yields could rise to about 4.60%, assuming the market ends up pricing in three 25 basis point Fed hikes. In this context, we expect a flattening of the yield curve. Our forecast of an additional 35 basis points increase in Fed Funds will exert further upward pressure on short-term rates. We expect this to moderate the rise in long-term rates, leading to further yield curve flattening.
The impact on risky assets is more nuanced. In our previous scenario regarding Fed cuts, we forecast a moderate widening of credit spreads, largely due to tightening financial conditions caused by rising inflation expectations and higher long-term rates. This impulse will be muted, but Fed rate hikes also entail a higher cost of credit that could strain corporate profitability and cause some spread widening. The determining factor could be that markets will be reassured by bold measures taken to control inflation amid a strong US economy, which should limit any spread widening.
