Daleep Singh, Chief Global Economist & Robert Sockin, chief US economist at PGIM, share their insights on the US economy, assessing the current Fed outlook.
The US economy continues to power along with above trend growth, above target inflation, and now a warming labour market. These factors all suggest that the Fed policy will turn more hawkish.
As a result, PGIM has updated its current Fed outlook, now expecting three 25 basis point rate hikes this year. These rate hikes are likely to be relatively short-lived, and we anticipate three cuts of 25 basis points in 2027, followed by one final rate cut in 2028 for a terminal rate of 3.375%–a notch lower than where the policy rate sits today.
US Economy: Running Hot
Five key factors have led us to adjust our rates call:
1.) Above-trend US growth: The US economy continues to show remarkable resilience. We expect real GDP growth at 2.3% this year, extending a streak of above-trend results. US outperformance is being driven by the AI buildout, the wealth effect on consumption, and fiscal stimulus. Higher-than-usual 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 AI ecosystem, continue to power spending among upper-income households.
2.) High inflation with upside risks: US headline PCE inflation has surged to 3.8% year-over-year as of April, the latest leg driven by higher energy prices. Core PCE inflation, which excludes food and energy prices, is also uncomfortably high at 3.3%. The good news so far, as further highlighted by CPI data for May, is that pressures from the Iran conflict have yet to show up in core prices. Still, we see risks to inflation as skewed to the upside for a range of reasons, perhaps most concerning among them is that leading indicators of the “pipeline pressure” for consumer inflation, such as the producer price index, remain very firm.
3.) US labour market is warming up: The labour market is somewhere between stabilisation and acceleration, trending towards the latter. Strikingly, payrolls growth has averaged 188k per month for the last three months, up sharply from the approximate pace of 10k per month in 2025. While other labour market indicators such as wage growth and the quits rate do not suggest the labour market is heating, we expect these data to lag the renewed strength we are seeing in hiring.
4.) Hawkish Fedspeak: The hawkish shift in Fed communication has been remarkable over the last several weeks, particularly in that it continued as Kevin Warsh took over as Fed Chair. A month ago, some Fed officials were still talking about rates moving down over time, but this type of communication has largely disappeared. More officials are now talking about the potential for hiking rates, and in many cases, they are broadening out the criteria for what might justify rate hikes.
5.) Fed Chair Warsh’s disposition: How Kevin Warsh shows up as Fed Chair has been a months-long debate. Will he hold his belief that the Fed needs to hike into supply shocks, or will he argue the underlying inflation trend looks favourable and rates should move down over time? With conditions having changed rapidly on the ground over the last few months, we anticipate it will be the former. Even if data on core inflation is better than expected, inflation is still far from the Fed’s target, and Warsh may need a “Volcker moment” upfront to cement his credibility and help bring inflation towards 2%. The biggest question for us, and the greatest risk to our forecast, is whether there will be political cover for Warsh to raise rates. If rate hikes are framed as a “precautionary” effort to counter supply-side inflation and the recent upward lurch in long end Treasuries yields, we believe there will be.
Market Implications
First, US Treasury yields are likely to see further upward pressure as the Fed embarks on a precautionary hiking cycle. According to our model, for UST yields we estimate 10-year yields could rise to c.4.60% assuming three 25bp Fed hikes are eventually priced. We expect the yield curve to flatten in this environment. Our view of a further 35bp increase in Fed Funds will put further upward pressure on front end rates. We expect this to temper the increase in long end rates, leading to a further flattening of the yield curve.
The impact on risky assets is more nuanced. In our previous scenario for Fed cuts, we expected credit spreads to widen moderately, largely due to tighter financial conditions driven by higher inflation expectations and higher long end rates. That impulse will be reduced, but higher Fed policy rates also involve a rise in the cost of credit which could challenge corporate profitability and lead to some spread widening. The tipping factor may be that markets will be reassured by the bold actions to control inflation against a backdrop of a strong US economy, which should limit any spread widening.
Perhaps the most clear-cut market implication of tighter Fed policy is a stronger US dollar. We had assumed that easier Fed policy, increased policy uncertainty, and higher inflation expectations would hurt the USD. With the Fed on the front foot and the US economy in good shape and better placed to weather energy shocks, we believe the USD would be more likely to appreciate versus major currencies.
