A blockbuster May jobs report has shifted rate markets dramatically, pushing the probability of a Federal Reserve interest rate increase by December to levels that would have seemed unlikely just weeks ago, when rate cuts were still the dominant market expectation.

U.S. interest rate futures priced in a 68.4% chance of Fed tightening by the December policy meeting following the May payroll release, up sharply from 52% late on Thursday, according to CME FedWatch data. 

For the June meeting, markets still expect the Fed to hold rates steady in the 3.50% to 3.75% range.

What the Jobs Report Did to Market Expectations

The May payroll number caught markets off guard in a significant way.

Nonfarm payrolls rose by 172,000 jobs, nearly double the 85,000 that economists polled by Reuters had forecast. April’s count was also revised upward to 179,000, from the 115,000 initially reported. 

The combination of a massive May beat and meaningful upward revisions to prior months presented a labor market picture far more robust than most forecasters had been working with.

Bradford Smith, portfolio manager at Janus Henderson Investors, described the report as a “barnburner,” noting that the 172,000 figure topped even the most optimistic individual economist estimate.

“This sets up a scenario where the Fed could follow market pricing and embrace some insurance hikes,” Smith said.

Warsh Faces a Divided Fed and a Difficult Inflation Problem

The jobs report lands as new Federal Reserve Chair Kevin Warsh prepares to preside over his first policy meeting later this month, inheriting a central bank that is already internally divided on the direction of policy.

Several Fed officials have already signaled they want to change the language in the Fed’s policy statement to remove any implication that the next move will be a rate cut. 

Others remain cautious about tightening into an uncertain economic environment still shaped heavily by the Iran war and its ongoing disruption of global energy markets.

Market participants say stubborn inflation will present a more immediate challenge for Warsh than the employment picture. 

With payrolls growing well above trend and the unemployment rate holding steady at 4.3%, the labor market side of the Fed’s dual mandate is no longer a concern that argues for easy policy.

The complication, analysts note, is that the current inflation environment is being driven by factors that higher interest rates cannot effectively address.

Raising the federal funds rate will tighten financial conditions and reduce domestic demand, but it will not lower global oil prices or reopen the Strait of Hormuz. The energy-driven component of inflation, which has been the primary force pushing the PCE price index to its highest level in three years, is a supply shock rather than a demand problem. 

Rate hikes address demand-side inflation more effectively than supply-side inflation, which means the Fed risks slowing the economy and raising unemployment without necessarily bringing down the specific prices that are causing the most pain for American households.

The Shift in Rate Cut Expectations

The reversal in market pricing over recent weeks has been dramatic.

At the start of the year, rate futures were pricing in multiple Fed rate cuts over the course of 2026. The combination of persistently elevated inflation driven by the Iran war, a labor market that has consistently outperformed expectations, and growing hawkish signaling from Fed officials has erased those expectations entirely. 

The debate in markets has now shifted from how many cuts the Fed will deliver to whether the central bank will raise rates before the year is out.

Hopes for rate cuts have not just diminished, they have effectively vanished for the foreseeable future, with markets now anticipating the Fed will remain on hold through the summer before potentially moving to tighten conditions in the fall.

The June 17 meeting, Warsh’s first as chair, will be closely watched for any signal about how the new leadership intends to navigate an environment where inflation is moving in the wrong direction and the labor market is giving the Fed little reason to hold back.