Citadel Securities: Inflation Has Become the Main Risk, The Federal Reserve Should Switch to Raising Interest Rates as Soon as Possible

US inflation is heating up again, presenting the Federal Reserve with a new and severe test for its monetary policy.

Citadel Securities has issued a warning, arguing that the Fed should shift its policy focus from supporting employment to combating inflation and adjust its stance as soon as possible.

Nohshad Shah, Head of Fixed Income Sales for Europe, Middle East, and Africa at the firm, pointed out that the oil price shock has triggered the largest jump in inflation since 2023. At the same time, the wave of AI investment combined with continued financial easing is accelerating the economy.

Former New York Fed President Bill Dudley said on Tuesday that inflation has persistently exceeded the 2% target since the pandemic ended, undermining the Fed's credibility in fighting inflation. Data from the interest rate swap market shows that a rate hike could start as early as the end of October this year, while a 25 basis point increase early next year is almost fully priced in by the market.

But the latest fund flows reveal the emergence of major buyers of cheap SOFR options, aiming to hedge against the Fed's rate hike premium.

After the long weekend ending May 26, the SOFR options market saw significant fund flows. Notably, buyers made large purchases of cheap "December call option butterfly spreads" to bet heavily on upside potential. The core goal of these positions is to target a pullback in currently priced Fed tightening (rate hikes) by year-end.

Oil price shock combined with the AI boom, inflation as the main contradiction

The surge in oil prices following the outbreak of US-Iran war is the direct trigger for the current acceleration in inflation. In April, the US Consumer Price Index (CPI) rose 3.8% year-on-year, hitting a new high in recent years.

Meanwhile, stock markets have continued to rise, driven by the AI transformation described by Shah, while US financial conditions have become increasingly loose. The influx of large-scale technology investment spending has further fueled economic growth.

Citadel Securities' models show that the Fed's current interest rate is close to the neutral range, neither stimulating nor restraining economic growth. Shah believes that this stance is "contradictory" to the market's pricing of strong economic expansion prospects—in an already robust economy, maintaining neutral rates means actual policy is relatively loose.

He described the current changes in the bond market as "awakening—gradually recognizing the classic demand-pull inflation risk faced by an overheated economy." Since the end of February, bond yields have surged.

Labor market accelerates again, wage inflation risks emerge

Employment data further supports these views. Shah says the latest weekly ADP figures show that if private sector hiring keeps pace, it will match the monthly addition of 170,000 to 180,000 jobs, indicating the labor market is showing signs of re-acceleration rather than the cooling expected by outsiders.

Especially noteworthy, Fed officials have acknowledged that, due to tightened immigration controls, the "breakeven employment growth" threshold needed to keep unemployment stable may have fallen to near zero. This means that the current job growth rate, if sustained, poses a real risk of reigniting wage inflation.

Additionally, Shah points out that recent data shows the energy price shock is starting to transmit to broader pricing behavior, and consumer inflation expectations are "moving in the wrong direction."

Hawkish voices rise within the Fed; several officials consider rate hikes

The Fed’s internal stance has shifted significantly. According to the minutes of the Fed's April meeting, most officials warned that if inflation remains high, rate hikes may be needed.

Although the interest rate swap market currently believes rate hikes may not begin until the end of October this year, an early 2025 hike of 25 basis points is considered almost certain.

Bill Dudley further pointed out in an interview that since the pandemic ended, inflation has persistently deviated from the 2% target, putting the Fed’s anti-inflation credibility under pressure. Once this erosion of credibility sets in, future policy actions will become much more difficult.

Trump's pressure and Waller's political dilemma

The political pressures surrounding the Fed are also not to be ignored. Trump has repeatedly criticized the Fed for not cutting rates enough. However, the accelerated rebound in inflation is putting his appointed Fed chair Waller in a dilemma.

Shah points out that Waller is widely perceived by the market as having a "goal to avoid a rate hike cycle," but current inflation and employment data are gradually narrowing that option.

Shah wrote: "Under these circumstances, any Fed chair will find it hard to avoid the choice of raising rates."

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