The Federal Reserve is widely expected to keep interest rates unchanged at its July policy meeting, despite the recent surge in oil prices. According to Citi, financial markets may be overestimating the likelihood of an immediate rate hike.
The bank argues that the latest inflation and employment figures show that price pressures are continuing to ease. As a result, policymakers may struggle to justify tightening monetary policy at this stage.
Oil Price Surge Raises Rate Hike Speculation
Following the sharp increase in crude oil prices, markets have priced in approximately a 30% chance that the Fed will raise interest rates.
However, Citi expects policymakers to leave borrowing costs unchanged. The bank pointed to weaker-than-expected core inflation in June and a slowdown in payroll growth as key reasons for the Fed to remain cautious.
Furthermore, officials decided against raising rates at their June meeting. Citi believes the latest economic data does not provide a strong enough reason for the central bank to reverse that decision in July.
Investors Remain Divided Ahead of Fed Decision
Markets are split ahead of Wednesday’s Federal Reserve announcement. Rising energy prices have increased concerns that inflation could accelerate again, leading some investors to prepare for a possible rate hike.
Nevertheless, Citi believes signs of cooling inflation and weaker labor market conditions will persuade most policymakers to keep rates steady.
The bank also expects investors to interpret an unchanged rate decision as dovish, even if several officials vote in favor of higher rates. Such an outcome could push U.S. Treasury yields lower and weaken the U.S. dollar.
Several Fed Officials Could Support a Rate Hike
Citi expects multiple policymakers to dissent from the majority decision and vote for higher interest rates.
Cleveland Fed President Beth Hammack and Dallas Fed President Lorie Logan are among the officials Citi believes could support an increase.
However, the number of dissenting votes will be important. According to the bank, more than two votes in favor of a rate hike would send a noticeably stronger hawkish signal to financial markets.
Citi Expects Markets to View a Hold as Dovish
Citi believes that keeping rates unchanged would likely be seen as a dovish policy outcome.
The bank expects most Federal Reserve officials to conclude that the U.S. economy is not overheating. It highlighted several indicators supporting that view, including slowing job creation, a sharp decline in labor force participation and June core Consumer Price Index data that was broadly consistent with inflation trends seen before the pandemic.
Therefore, Citi expects an unchanged decision to place downward pressure on both Treasury yields and the U.S. dollar.
Would Higher Oil Prices Trigger a Surprise Hike?
Some investors believe Fed Chair Kevin Warsh could respond to the oil price spike with an unexpected rate increase. Such a move could be intended to reinforce the central bank’s commitment to controlling inflation.
Citi, however, considers that scenario unlikely.
The bank argues that a surprise hike would conflict with falling market-based inflation expectations. It would also appear inconsistent with Warsh’s previous comments suggesting that supply-driven price increases should not automatically lead to tighter monetary policy.
Oil-related inflation can raise consumer prices, but it does not necessarily reflect excessive demand across the wider economy. For that reason, Citi believes the Fed will avoid reacting too aggressively to the latest energy shock.
Warsh May Avoid Offering Forward Guidance
Citi also expects Warsh to provide limited guidance during his post-meeting press conference.
The Fed chair may avoid giving markets clear indications about the future direction of monetary policy. This would be consistent with his preference for keeping the central bank’s options open rather than committing to a specific interest-rate path.
However, investors will closely examine his language. Citi said that any repetition of recent comments downplaying inflation risks associated with artificial intelligence could be viewed as slightly dovish.
The same could apply if Warsh focuses on alternative inflation measures that indicate weaker price pressures.
Fed Rate Cuts Could Return in October
Looking beyond the July meeting, Citi expects inflation and employment data to continue softening over the coming months.
Additional evidence of weaker job growth and subdued inflation could remove the remaining expectations for another interest rate increase. It may also create the conditions for the Federal Reserve to restart its rate-cutting cycle.
According to Citi’s forecast, the next Fed rate cut could arrive as early as October.
