The tepid June non-farm payrolls report is fundamentally shifting the Federal Reserve's policy calculus.
In a U.S. economic weekly report issued on July 2, Citi Research clearly stated that the June employment report strongly refutes the necessity for further interest rate hikes. Several factors that previously supported a hawkish stance—rising oil prices, accelerating wage growth, and core PCE exceeding target—have now dissipated. The rationale for raising rates "no longer exists." The firm maintains its baseline forecast: as the unemployment rate rises in the coming months, the Federal Reserve will restart interest rate cuts in October.
This assessment has direct implications for markets. If Citi's prediction materializes, the Fed's policy rate target range would be lowered from the current 3.5%-3.75% to 3.25%-3.5% in October, with another cut to 3.0%-3.25% before year-end.
Non-Farm Payrolls Miss Expectations Significantly; Quality of Unemployment Rate Drop Questioned
U.S. non-farm payrolls increased by only 57,000 in June, far below prior expectations, with the previous two months' data revised down by a combined 74,000. After these revisions, the three-month average monthly job growth has fallen to approximately 111,000, a significant drop from the pre-revision level exceeding 180,000.
By sector, leisure and hospitality employment fell by 61,000, confirming that the anomalous growth in this sector in May stemmed from seasonal adjustment issues rather than World Cup-related hiring demand. Concurrently, JOLTS data shows that while job openings remain relatively strong, the hiring rate continues to be sluggish, corroborating the weakening trend in the non-farm payrolls data.
Notably, the unemployment rate fell from 4.296% to 4.189% in June, but this decline was entirely due to a sharp drop in the labor force participation rate from 61.8% to 61.5%, primarily driven by a steep decline in participation among the 25-34 age group.
Citi views this as more likely statistical "noise" than a genuine economic signal—if the participation rate had remained unchanged, the unemployment rate would have actually risen above 4.5%. As the participation rate struggles to decline further or even rebounds, the unemployment rate is expected to trend upward in the coming months.
Inflationary Pressures Ease in Tandem; Core PCE May Face Downward Revision
On the inflation front, Citi believes multiple factors are collectively reducing price pressures. Oil prices have retreated to pre-conflict levels, and July's CPI and PCE data are expected to show month-on-month declines. A further slowdown in housing rent prices will also weigh down core CPI and core PCE.
The most significant inflation development last week was the announcement of a methodology revision for core PCE—the new method adopts a more reasonable price adjustment approach for AI-related goods. Estimates suggest the revised core PCE year-on-year growth rate could be lowered by 20 to 30 basis points, with the official reflection of this change set for September.
Combined with the latest forecasts, the core PCE year-on-year growth rate is expected to gradually decline from the current level of about 3.4% to 3.0% by the end of 2026, and further to a range of 2.1%-2.2% by mid-2027.
Fed Chair Maintains Neutral Stance; Path to October Rate Cut Becomes Clearer
Regarding policy signals, Federal Reserve Chair Warsh's remarks continued his consistent stance of "not providing forward guidance," explicitly stating he would not comment on data from the past two weeks. Although some market participants interpreted his statements at the June FOMC press conference as leaning hawkish, a more accurate characterization is that he was "maintaining silence on future policy, thus adopting a neutral position." Warsh confirmed in Sintra that inflation risks have decreased over the past four weeks and mentioned the potential for AI to boost productivity. These statements were "not surprising and clearly not hawkish."
The baseline forecast indicates the FOMC will hold rates steady at its July and September meetings. The first 25-basis-point rate cut is projected for the October 28 meeting, followed by another 25-basis-point cut in December, bringing the federal funds rate target range to 3.0%-3.25% by year-end. The forecast also includes three additional rate cuts in 2027, with a terminal rate range of 2.75%-3.0%.
Furthermore, Citi expects U.S. second-quarter real GDP to grow at a seasonally adjusted annualized rate of 1.9%, with consumption contributing 1.3 percentage points and net exports dragging down growth by approximately 1.2 percentage points. The overall economic slowdown further supports the logic for the Federal Reserve to pivot towards an accommodative policy stance.
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