What rate cut? The Fed's next move could be a hike if inflation stays stubbornly high, legendary investor says

Higher interest rates aren't a far-fetched prospect this year, as the risk of an inflationary rebound looms over the Federal Reserve, Rob Arnott said.

The legendary investor is forecasting that inflation will be 3.5%-5% by the end of the year, he told Bloomberg TV. The higher the number, the lower the chances of a rate-cutting cycle, he outlined.

"Four to five [percent inflation] is going to be seen as a real blow and would keep the Fed from cutting and might encourage them to hike again," said the Research Affiliates founder.

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Markets have carefully monitored inflation month-to-month, with investors eager to see the figure fall low enough to prompt a Fed policy pivot. For now, the central bank has delayed rate cuts, insisting it needs to see clear disinflation in data.

But while May notched a cooler-than-expected consumer price index report, a continued cooldown might not be as easy to achieve between now and the end of this year, Arnott said.

That's as the inflation gauge uses last year's readings in its calculations — as it happens, inflation in the final stretch of 2023 was benign:

"If it was low, abnormally low inflation during the latter months of last year, then upward pressure on inflation is more likely than downward," he explained.

For its part, the Fed has said it sees just one 25-basis point rate cut this year, below the two to three cuts predicted by markets. The central bank has received criticism for being too data-dependent in its decision-making.

If inflation eases further, the economy may be softening enough to justify the Fed loosening monetary policy, though Arnott is not entirely convinced the one rate cut will do much to help boost the economy.

"It's not clear to me it does anything other than perk up enthusiasm," he said, referring to the market's bull run, which has been egged on by the prospect of lower interest rates.

He added: "I think the Fed has covered it to stimulate bubbles, but not to stimulate the economy."