The minutes from the Federal Reserve's May FOMC meeting released the most hawkish signals in recent years, but Citigroup Research argues that the market has overreacted in repricing the Fed's policy trajectory. According to their analysis, expectations for rate cuts are being underestimated, and the perception of an imminent hawkish shift by incoming Chair Walsh is exaggerated.
The FOMC minutes from late April, published on May 20 Eastern Time, revealed that "most" participants believed a policy tightening could become appropriate if inflation persists above 2%. "Many" officials expressed a preference to remove language from the post-meeting statement that hinted at an easing bias. This marked the first time in nearly two years that Fed officials seriously considered the possibility of a rate hike during a meeting, indicating a substantial shift in the direction of internal debate. Following the release, the two-year Treasury yield rose, with markets further pricing out rate cuts and beginning to factor in the probability of a hike within the year.
Citigroup Research, in a report published the same day, explicitly stated that the market's pricing is incorrect. Economists including Andrew Hollenhorst noted that the rise in the two-year yield and the market's dismissal of rate cut expectations contradict Citigroup's assessment of the Fed's policy path. The probability of rate cuts in both the current and next year is higher than that of hikes, and Citigroup expects the Fed to resume cutting rates in September.
The hawkish tone in the April FOMC minutes was the strongest in years. The internal divisions presented were the most significant since 1992. Among the 12 voting members, four dissented on the post-meeting statement—while Governor Michelle Bowman insisted on a 25-basis-point cut, the other three dissented because they did not support retaining the easing-bias language.
The minutes indicated that participants generally judged that, given persistently high inflation data and the high uncertainty surrounding the duration and economic impact of the Middle East conflict, maintaining the current policy stance might last longer than previously anticipated. "Most" participants emphasized that if inflation continues above 2%, some degree of policy tightening could become appropriate. "Many" officials indicated they had initially leaned toward removing language from the statement that suggested an easing bias.
Nick Timiraos, a journalist often referred to as the "Fed Whisperer," commented that under the dual influences of the Middle East conflict and the AI boom, the Fed—on the cusp of a leadership transition—has reshaped its interest rate outlook. Officials have essentially set aside the core question that dominated internal debate over the past two years, "whether to cut rates," and are now more seriously weighing the opposite possibility: whether to hike rates.
Compared to the March minutes, the hawkish inclination in the April minutes deepened significantly. In March, only "some" officials believed the Fed had reason to provide balanced policy guidance, whereas in April, this group expanded to "many" officials favoring more neutral language in the policy statement.
Citigroup Research emphasized that these minutes reflect discussions from meetings under former Chair Powell's tenure and do not represent the policy leanings of incoming Chair Walsh. Citigroup pointed out that a prevailing market narrative over the past week suggests Walsh will pivot and abandon his previous support for rate cuts. Citigroup explicitly countered this, arguing that the more likely scenario is that Walsh will not push for a rate cut at the June meeting but will continue to support an eventual reduction in the policy rate. Walsh will hold his first press conference as chair in June, where he will need to address the hawkish tone presented in the minutes directly.
Citigroup expects the Fed to resume rate cuts in September as monthly core inflation data cools and the unemployment rate rises. Under Citigroup's baseline scenario, the probability of rate cuts in both the current and next year is higher than that of hikes.
Citigroup also noted in its report that while expectations for Fed rate cuts are currently underestimated by the market, there is a lack of catalysts in the near term to trigger significant repricing unless the situation regarding a blockade of the Strait of Hormuz is resolved.
From an economic fundamental perspective, Citigroup believes the U.S. economy is currently operating near its potential growth rate of about 2%. Consumer spending remains resilient despite multiple shocks like rising energy prices, and AI-related capital expenditure continues to provide growth momentum. Both factors are unlikely to reverse in the short term, making a significant policy expectation repricing triggered by economic data alone less probable.
Regarding inflation, Citigroup argues that core PCE exaggerates the degree to which Fed policy is deviating from its target. Core PCE may remain above 3% for the remainder of the year, partly because the PCE index assigns a higher weight to price indices driven by AI demand. The trimmed-mean PCE, which excludes extreme values, is currently running at 2.4%, not far from the Fed's 2% target. Citigroup expects future core PCE readings to trend closer to the 2% target on an annualized basis.
Citigroup judges that for the market to reduce implied probabilities of rate hikes and increase pricing for cuts, clear signals of labor market weakening may be necessary. Citigroup expects seasonal factors to produce softer employment data in the coming months. A combination of rising unemployment, increasing jobless claims, and inflation data that no longer causes concern will prompt the Fed to resume rate cuts in September. However, the market may need to wait for the release of both the May and June employment reports before truly adjusting its implied probabilities for hikes and cuts.
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