The Federal Reserve's April FOMC minutes released the strongest hawkish signal in recent years, with officials seriously weighing the possibility of an interest rate hike for the first time, leading the market to significantly cut pricing for rate cuts. However, Citigroup Research countered this trend: the market pricing has been excessive, and the expectations for rate cuts have been severely underestimated. The greater likelihood is that Waller will not push for a rate cut at the June meeting, but will still support a future rate reduction, predicting that the window for a rate cut will still open in September, with a key catalyst being when the labor market weakens.

Written by: Zhao Ying

Source: Wall Street Journal

The latest FOMC meeting minutes from the Federal Reserve have released the strongest hawkish signals in recent years, but Citigroup Research believes that the market's repricing of the Federal Reserve's policy direction has been excessive and that expectations for rate cuts are underestimated, while judgments about the hawkish turn of Waller, who is about to take over the chair position, are exaggerated.

According to the minutes of the April FOMC meeting released on May 20, Eastern Time, "most" attendees believed that if inflation remains above 2%, a policy tightening may become appropriate; "many" officials were inclined to remove wording in the post-meeting statement that implied an easing tendency. This is the first time in two years that Federal Reserve officials have seriously considered the possibility of raising interest rates during a meeting, marking a substantial shift in the direction of internal debate. After the minutes were released, the two-year U.S. Treasury yield rose, and the market further reduced rate cut pricing and began to price in the probability of a rate hike within the year.

According to Wind Trading Desk, Citigroup Research clearly stated in its report on the day of the minutes release that it believes the market pricing is incorrect. Citigroup economists, including Andrew Hollenhorst, pointed out that the rise in the two-year U.S. Treasury yield and the pricing out of rate cut expectations are contrary to Citigroup's judgment on the Federal Reserve's policy path. The probability of rate cuts in the next two years is higher than that of rate hikes, and it is expected that the Federal Reserve will restart rate cuts in September.

The Minutes' Hawkish Signal is at a Recent High

The internal divisions reflected in the April FOMC meeting minutes are the most significant since 1992. Out of 12 voting members, four cast dissenting votes on the post-meeting statement—except for Governor Milan, who insisted on a 25 basis point rate cut, the other three dissenting members opposed the statement for not supporting the removal of the easing language.

The minutes reveal that attendees generally judge that, given inflation data remains high and the prolonged uncertainty of the Middle East conflict and its economic impact, the duration of maintaining the current policy stance may exceed previous expectations. "Most" attendees emphasized that if inflation remains above 2%, some degree of policy tightening may become appropriate; "many" officials expressed a desire to eliminate wording that suggests easing in the post-meeting statement.

Journalist Nick Timiraos, known as the "new Federal Reserve news agency," commented that under the dual influences of the Middle East conflict and the AI boom, the Federal Reserve, which is about to undergo a leadership change, has reshaped its interest rate outlook—officials have actually shelved the core issue that has dominated internal debates for the past two years, "should we cut rates?" to more seriously consider the opposite possibility: "should we raise rates?"

Compared to the March minutes, the hawkish tendency in the April minutes has significantly deepened. In the March minutes, only "some" officials believed that the Federal Reserve had reasons to provide balanced policy guidance, whereas in the April minutes, this group has expanded to "many" officials, who lean towards using more neutral wording in the policy statement.

Citigroup: The Minutes Do Not Represent Waller's Position

Citigroup Research emphasized that these minutes reflect discussions from former Chair Powell's term and do not represent the policy tendencies of incoming Chair Waller.

Citigroup pointed out that a judgment has recently gained popularity in the market—that Waller will turn and abandon previous support for rate cuts. Citigroup explicitly counters this, believing the greater likelihood is that: Waller will not push for a rate cut at the June meeting but will still support a future reduction in policy interest rates. Waller will host his first press conference at the June meeting, where he will need to directly respond to the hawkish tendencies presented in the minutes.

Citigroup expects that as monthly core inflation data cools and the unemployment rate rises, the Federal Reserve will restart rate cuts in September. In Citigroup's baseline scenario, the probabilities of rate cuts in the next two years are higher than those of rate hikes.

The Catalyst for Rate Cuts: Waiting for a Weak Labor Market

Citigroup also pointed out in its report that current expectations for Federal Reserve rate cuts are underestimated by the market, but there lacks a catalyst in the short term to trigger a significant repricing, unless the situation blocking the Strait of Hormuz is resolved.

From an economic fundamentals perspective, Citigroup believes the U.S. economy is currently operating at about a 2% potential growth rate, with consumer spending remaining resilient under multiple shocks like rising energy prices, and AI capital expenditures continue to provide growth momentum, both of which are unlikely to reverse in the short term, making it less likely for policy expectations to be significantly repriced based solely on economic data.

On the inflation front, Citigroup believes that the core PCE's deviation from the Federal Reserve's policy target has been exaggerated. The core PCE may remain above 3% for the rest of this year, but this largely stems from PCE assigning a higher weight to price indices driven by AI demand. The trimmed mean PCE, excluding extremes, currently runs at 2.4%, not far from the Federal Reserve's 2% target, and Citigroup expects that future core PCE readings will approach the 2% target on an annualized rate.

Citigroup assesses that for the market to reduce the implied probability of interest rate hikes and increase pricing for rate cuts, there may need to be clear signals of weakness in the labor market. Citigroup expects that seasonal factors will bring relatively weak employment data in the coming months, with an increase in the unemployment rate and the rise in jobless claims, combined with inflation data no longer being worrisome, will prompt the Federal Reserve to restart rate cuts in September. However, the market may need to wait until the employment reports for May and June are released before truly adjusting the implied probabilities for interest rate hikes and cuts.