The U.S. unemployment rate in May was 4.3%, not yet reaching the line Morgan Stanley mentioned. But the problem is that inflation is already here: PCE is 4.1% year-over-year, and core PCE is 3.4% year-over-year—neither of which are numbers the Fed can easily move past.

Morgan Stanley was very restrained this time: the base case is still that the Fed will stay on hold for the rest of the year. The real trigger condition is if the unemployment rate drops below 4% or core inflation continues to hover above 0.3% month-over-month.

In market language: as long as employment heats up a bit more and inflation remains a bit stickier, rate hikes are not just a tail risk.

That's why "good employment" isn't necessarily good news now.

Previously, the market could console itself: inflation mainly comes from oil prices, tariffs, and supply shocks. Once energy falls, the Fed can wait a bit longer. But if employment doesn't loosen, consumption doesn't collapse, and core inflation doesn't come down, the Fed will find itself with very few options left.

High inflation meets low unemployment—the policy balance naturally tilts toward rate hikes.

Kashkari's shift is a signal. In March, he still expected one rate cut this year; now he has changed to expecting one rate hike this year. In the dot plot, half of the officials also set the year-end rate above the current level.

This isn't a full hawkish turn, but it's enough to make the market uncomfortable.

For risk assets, the most troublesome thing isn't an immediate rate hike, but the continued elimination of "rate cut expectations." Growth stocks, high-valuation AI, and crypto assets all rely on long-term cash flows and liquidity expectations. As long as the dollar and interest rates remain overhead, rebounds will be very data-dependent.

The two sets of numbers to watch next are:

Whether the unemployment rate will fall back below 4%;

Whether core PCE month-over-month can drop to 0.2% or lower.

The former determines whether the Fed has reason to stay tough; the latter determines whether the market dares to reprice easing.

This is not to say "the Fed will definitely hike rates." It's more like drawing a line for the second half of the year:

The stronger employment is and the stickier inflation is, the more uncomfortable risk assets become.
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