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Fed is in no hurry to raise interest rates in the US
The Fed does not need to rush into rate hikes, but the market still prices in uncertainty
Persistently elevated inflation in the U.S. is today, according to Citi, driven primarily by an external supply shock — in other words, by factors pushing up prices from the cost side rather than by an overheating economy. In such a situation, the Fed has no reason to quickly return to further interest-rate hikes, said Andrew Hollenhorst, Citi’s chief U.S. economist.
The bank assumes that rates may not rise in either October or December. As Hollenhorst stressed, Citi remains skeptical about how much the Fed will raise rates in the current cycle. The uncertainty is heightened by the fact that the bank is led by Kevin Warsh, who prefers to use central bank communication tools less often, giving markets fewer clues about future decisions.
Oil prices also remain an important factor. The economist explained that, all else being equal, higher energy prices make the Fed more hawkish, meaning more inclined toward tighter policy, while lower prices push it toward a more accommodative stance. The market had even priced in hikes of as much as 150 bp, but Citi sees no economic justification for that.
According to Hollenhorst, the central bank is acting today primarily in the name of credibility. The Fed fears that if inflation stays too high for too long, the public and markets will conclude that the institution is not taking its target seriously enough. At the same time, key fundamental indicators, especially in the labor market, do not show an overheating economy. Wage growth has returned to normal, the unemployment rate stands at 4,1 proc., and job creation remains rather weak.
The economist added that nothing in the U.S. economy points to domestically generated inflationary pressure. All of the pressure is coming from outside and is the result of higher energy prices. Historically, in the case of such a supply shock, the Fed did not raise interest rates, because further tightening could only deepen the slowdown caused by more expensive energy.
At the same time, Citi notes that over the past few weeks the market has scaled back earlier expectations for October after a series of macroeconomic data releases and comments from some Fed members. December is now mentioned more often, but much will depend on the next readings and statements. A scenario with no hike in either October or December remains possible.
Hollenhorst also noted that markets are assuming an increase in the neutral rate, meaning the level of rates that neither stimulates nor restrains the economy. In his view, those expectations are partly justified by higher long-term yields and the assumption that the central bank will keep policy restrictive for longer. On the other hand, high equity valuations suggest that, from the stock market’s perspective, that level has not yet been reached.
Over the longer term, Citi believes that the 2 proc. inflation target may turn out to be too narrow, especially given tariffs, energy prices and geopolitical factors. The economist stressed, however, that changing the target is not possible today, because the Fed must first bring inflation down to 2 proc., and any attempt to revise it could damage the central bank’s credibility.
The midterm elections also matter, because according to Citi the base case assumes a Republican president and at least one chamber of Congress controlled by Democrats. Such an arrangement usually limits the number of new laws and makes it harder to agree on the debt ceiling and avoid a shutdown, meaning a partial halt to the administration’s work. In Hollenhorst’s view, a delay or rejection of planned budget savings becomes more likely next year.
The economist recalled that the deficit is already high and could remain at 6,5 proc. of GDP for several years. Added to that is the risk of further gains in bond yields, which rise as concerns about debt grow. Citi also sees an effect from the oil market: if energy prices fall, bond yields may also move lower, although it is hard to say when that will happen.
In the bank’s view, the past six months have shown that companies were able to absorb part of the higher energy costs thanks to relatively high margins. That situation may be changing, however, as diesel prices, important for freight transport, have recently risen much more sharply than in previous months. At the same time, despite no resolution to the conflict in the Middle East, oil supply on the market is increasing, which should support lower prices over the course of the year.
Hollenhorst added that after the election, a higher deficit may support GDP growth only in the short term. In the background are rising bond yields, concerns about debt and the risk of a weaker economy. In its September 25 report, Citi raised its global GDP growth forecast to 2,6 proc., and now expects 2,8 proc., with pressure linked to the conflict in the Middle East gradually easing.
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