Why Citi says the Fed could be setting up for a dovish surprise

Investing.com - Core PCE inflation annualizing around 2% month after month would likely qualify as inflation slowing at "sufficient speed" — a threshold that could open the door to a dovish shift from the Federal Reserve, Citi economist Andrew Hollenhorst argued in a note.

"We do not judge the US economy as overheating and consequently did not and do not see a strong case for rate hikes," he wrote.

The Fed minutes, he noted, suggest at least some officials share that diagnosis: "They also do not see the economy as overheating but agreed to a hike for 'risk management' given upside risks to inflation."

Hollenhorst directly addresses one of the more persistent concerns in current rate debates: whether rising energy prices since spring will bleed into core inflation. He is skeptical.

"We are not projecting that higher energy prices will meaningfully raise core inflation," he said.

"Since energy costs first increased in the spring, they have not been broadly passed-through to consumer goods. With real consumer incomes having slowed, there is no reason to think consumers would be more willing to accept higher prices now."

The fed funds target rate currently stands at 5.50%–5.75%, following the most recent "risk management" hike. The latest core PCE reading came in at 2.7% year-on-year, while core CPI has been running near 3.2% year-on-year — both still above the Fed's 2% target, though trending lower.

Fed funds futures markets are currently pricing in fewer than two full cuts over the next 12 months, reflecting lingering uncertainty about the pace of disinflation. It is against that backdrop that Hollenhorst's 2% annualized core PCE framework is meant to be read.

On the inflation trajectory itself, Hollenhorst is constructive for the months ahead.

"In our base case, core inflation will stay cooler over the next four months, adding to evidence that underlying inflation is slowing toward target," he wrote.

He does flag that January and February inflation readings tend to be seasonally strong, but still expects year-on-year figures to continue declining through that period, per Citi's projections.

The near-term watch point is September core inflation, where Hollenhorst sees specific downside risk. "There is particular downside risk to September core inflation as the August spike in cell phone service prices may reverse," he noted.

A reversal in that category could produce a softer-than-expected September print. Warsh has declined to define what pace of deceleration would constitute inflation slowing "at sufficient speed", language that has left markets without a clear benchmark.

"It seems reasonable to assume core PCE inflation annualizing around 2% month after month would qualify," the economist noted even if the Fed Chair himself has not specified a concrete level to monitor.

Original Article

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