The latest report from Citi points out that the Federal Reserve's policy reaction function has become more sensitive to current inflation data and energy prices. Even if the upcoming nonfarm payrolls report comes in below expectations, it will be difficult to shake the market's more than 50% pricing of a rate hike. September core CPI could come in on the cool side, meaning a month-on-month reading of 0.2% or lower. If inflation cools as expected, it would provide support for officials leaning toward pausing rate hikes. The direction of the Fed's October meeting is increasingly dependent on a single inflation reading.
According to the report, Citi Research said in a report released on September 28 that the Fed's policy reaction function has become more sensitive to current inflation data and energy prices. Even if the upcoming employment data comes in below expectations, it will be difficult to materially shake the market's more than 50% pricing of an October rate hike, and the decisive factor will ultimately rest on the September core CPI reading.
The firm expects September nonfarm payrolls to increase by about 85,000, with the unemployment rate rising slightly from 4.1% to 4.2%. Citi Research economists Andrew Hollenhorst and Veronica Clark believe this outcome will not be enough to significantly lower market pricing for a rate hike. Only extreme scenarios, such as negative nonfarm payrolls or the unemployment rate jumping to 4.3%, could prompt the market to reassess the probability of a hike.
At the same time, Citi expects this Wednesday's core PCE inflation data to be revised down significantly, leaning dovish in direction. However, because the market has already anticipated this, the actual impact is expected to be quite limited. This means the suspense over whether the Fed will raise rates in October will be concentrated on the single data point of September core CPI, highly similar to the situation before the September policy meeting.
The bar for jobs data is high, making it hard to reverse rate hike expectations on its own
The report recalls that before the September policy meeting, Fed Governor Waller said that as long as August inflation data cooperated, he would support keeping rates unchanged. However, August core CPI came in at 0.3% month-on-month, above the market expectation of 0.2%, ultimately driving a repricing in the market. The Fed followed suit and delivered a 25 basis point rate hike.
This process clearly reveals the current logic of Fed decision-making: with the labor market still resilient and inflation not yet clearly declining, a single month's CPI reading already has the ability to influence the direction of policy. Citi points out that the market has now priced in more than a 50% probability of an October rate hike. On that basis, if employment data comes 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, and second, the unemployment rate jumping to 4.3%. While these two scenarios are not impossible, they are not the baseline expectation. In other words, the employment report is more likely to be a data point that "does not change the conclusion," and the market and officials will immediately turn their attention to inflation.
September core CPI: the key variable deciding an October rate hike
Citi believes September core CPI could come in on the cool side, meaning a month-on-month reading of 0.2% or lower. There are two reasons: first, persistent components such as housing have already shown signs of slowing; second, the strength in August core CPI partly stemmed from more volatile components such as mobile phone service plans, whose persistence is questionable.
If September core CPI cools as expected, it will provide support for officials leaning toward pausing rate hikes. Most Fed officials expect a total of 50 basis points of rate hikes this year according to the dot plot, and with the potential impact of sharply higher Treasury yields on the economy still to be observed, some officials were already inclined to hold steady at this point. This Wednesday's core PCE data will be revised down significantly, which leans dovish in policy direction.
However, the firm also emphasizes that because this downward revision is already within market expectations, its actual impact on the Fed's policy path and market pricing is expected to be quite limited. This judgment further strengthens Citi's core conclusion: with both employment and PCE data unlikely to change the bigger picture, the outcome of the October policy meeting will be highly concentrated on the single variable of September core CPI, and investors need to pay close attention to the timing of its release and the reading itself.
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