The direction of the Federal Reserve's October policy meeting is increasingly hinging on a single inflation reading.
According to Citi Research, which released a new report on September 28, the Fed's policy reaction function has become more sensitive to near-term inflation data and energy prices. Even if upcoming employment figures fall short of expectations, they will struggle to meaningfully shake market pricing of more than 50% odds for an October rate hike. The ultimate decisive factor will rest on the September core CPI reading.
The firm projects September nonfarm payrolls to rise by roughly 85,000, with the unemployment rate edging up to 4.2% from 4.1%. Citi Research economists Andrew Hollenhorst and Veronica Clark believe this outcome is not sufficient to significantly lower market pricing for a hike. Only extreme scenarios — such as negative nonfarm payrolls or the unemployment rate jumping to 4.3% — could prompt markets to reassess the probability of a rate increase.
Meanwhile, Citi expects Wednesday's core PCE inflation data to be revised down substantially, a dovish signal in direction, but since markets have already anticipated this, the actual impact is likely to be quite limited. This means the suspense over whether the Fed will hike in October will be concentrated on the single data point of September core CPI, closely mirroring the situation ahead of the September policy meeting.
The employment data bar is high, making it difficult to reverse rate hike expectations on its own
The report recalls that ahead of the September policy meeting, Fed Governor Waller said he would support keeping rates unchanged as long as August inflation data cooperated. However, August core CPI came in at 0.3% month-over-month, above the market's 0.2% expectation, ultimately driving a repricing in markets. The Fed followed suit and delivered a 25-basis-point hike.
This process clearly revealed the current logic behind Fed decision-making: with the labor market still resilient and inflation not yet clearly declining, a single month's CPI reading is capable of swaying the policy direction.
Citi notes that markets have already priced in more than a 50% probability of an October hike. On this basis, if employment data comes in close to expectations, its marginal impact on rate hike expectations will be very limited.
The firm believes only two scenarios could materially change market pricing: first, negative nonfarm payrolls; second, the unemployment rate jumping to 4.3%. While neither is impossible, neither is the base case. In other words, the employment report is more likely to be a data release that "does not change the conclusion," and both markets and officials will immediately turn their attention to inflation.
September core CPI: the key variable determining an October hike
Citi believes September core CPI could come in on the cooler side, namely 0.2% month-over-month or lower. There are two reasons: first, persistent components such as housing have shown signs of slowing; second, the strength in August core CPI was partly driven by volatile components such as mobile phone service plans, whose persistence is questionable.
If September core CPI cools as expected, it would provide ammunition for officials leaning toward pausing rate hikes. Most Fed officials' dot plots project a total of 50 basis points of hikes this year. Combined with the potential economic impact of the sharp rise in Treasury yields still yet to be observed, some officials were already inclined to hold steady at this point.
The core PCE data released on Wednesday will be revised down substantially, a dovish signal in direction for policy. However, the firm also emphasizes that since this downward revision is already within market expectations, its actual impact on the Fed's policy path and market pricing is likely to be quite limited.
This judgment further reinforces Citi's core conclusion: with both employment and PCE data unlikely to change the broader picture, the outcome of the October policy meeting will be highly concentrated on the single variable of September core CPI. Investors need to pay close attention to the release timing and reading of this data.
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