FOMC minutes sound hawkish again, but Citi strongly supports rate cuts: the market has misjudged Waller.

The minutes of the May FOMC meeting released by the Federal Reserve sent the most hawkish signal in recent years, but Citi Research believes that the market’s repricing of the Fed’s policy trajectory has been excessive, rate-cut expectations are underestimated, and the judgment that incoming Chairman Waller will turn more hawkish is overstated.

According to the FOMC minutes released on May 20th, Eastern Time, "most" participants believe it may be appropriate to tighten policy if inflation remains above 2%; "many" officials preferred removing language indicating an easing bias from the post-meeting statement. This marks the first time in nearly two years that Fed officials seriously weighed the possibility of a rate hike at the meeting, signaling a substantive shift in the direction of internal debate. After the minutes were released, the yield on the two-year U.S. Treasury rose, 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, Citi Research explicitly stated in its report on the day of the minutes release that the market's pricing is mistaken. Citi economists Andrew Hollenhorst and others pointed out that the rise in two-year U.S. Treasury yields and the elimination of rate-cut expectations run contrary to Citi's judgment of the Fed’s policy path. The probability of rate cuts this year and next is higher than that of rate hikes, and they expect the Fed to resume rate cuts in September.

Minutes’ hawkish signal strongest in recent years

The internal divergences presented in the late-April FOMC minutes are the most significant since 1992. Of the 12 voting members, four voted against the post-meeting statement—except for Governor Milan, who insisted on a 25 basis point rate cut, the other three dissented because they did not support maintaining easing bias language in the statement.

The minutes show that participants generally judged that, given inflation data remained elevated and the duration and economic impact of the Middle East conflict were highly uncertain, the length of time to maintain the current policy stance could exceed previous expectations. "Most" participants emphasized that some degree of policy tightening might become appropriate if inflation remains above 2%; "Many" officials said they originally favored removing the easing bias language from the post-meeting statement.

Nick Timiraos, known as the "new Fed newsletter" reporter, commented that under the dual impact of the Middle East conflict and the AI boom, and with Fed leadership soon changing, the Fed has reshaped its interest rate outlook—officials have essentially shelved the central topic of internal debate for the past two years, "whether to cut rates," and have begun to more seriously consider the opposite: whether to raise rates.

Compared to the March minutes, the April minutes’ hawkish bias deepened noticeably. In the March minutes, only "some" officials believed the Fed had reason to provide balanced policy guidance, while in April, this group expanded to "many" officials who favored using more neutral language in the policy statement.

Citi: The minutes do not represent Waller’s position

Citi Research emphasized that these minutes reflect meetings held under former Chairman Powell, and do not represent the policy stance of the incoming Chairman Waller.

Citi pointed out that there has been a popular market view over the past week—Waller will shift and abandon previous support for rate cuts. Citi clearly refutes this, arguing that a more likely scenario is: Waller will not push for a rate cut at the June meeting, but will continue to support eventually lowering policy rates. Waller will preside over his first press conference at the June meeting and will need to directly address the hawkish bias presented in the minutes.

Citi expects that as monthly core inflation cools and unemployment rises, the Fed will resume rate cuts in September. In Citi’s baseline scenario, the probability of rate cuts this year and next is higher than that of rate hikes.

Catalyst for rate cuts: waiting for a weakening labor market

Citi also noted in its report that market expectations for Fed rate cuts are currently underestimated, but lack a catalyst for a major repricing in the short term unless the situation in the Strait of Hormuz is resolved.

From the economic fundamentals, Citi believes the US economy is currently running at a potential growth rate of about 2%. Consumer spending remains resilient amid multiple shocks such as rising energy prices, and AI capital expenditure continues to support growth; neither is likely to reverse in the short term, making it unlikely that economic data alone will trigger a substantial repricing of policy expectations.

On inflation, Citi believes core PCE overstates the degree to which Fed policy deviates from its target. Core PCE may remain above 3% for the rest of the year, but this is partly because the PCE assigns high weighting to price indices driven by AI demand. The trimmed mean PCE, which excludes extreme values, is currently running at 2.4%, close to the Fed’s 2% target, and Citi expects the annualized reading of core PCE to approach the 2% target in the future.

Citi judges that to reduce the market's implicit probability of a rate hike and increase rate-cut pricing, noticeable signs of labor market weakness will be needed. Citi expects that seasonal factors will lead to soft employment data in the coming months, rising unemployment rates combined with more applications for unemployment benefits, and inflation data no longer causing concern will push the Fed to resume rate cuts in September. However, the market may need to wait until the May and June employment reports are released before truly adjusting implicit probabilities for rate hikes and cuts.

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The above highlights are from Wind Trading Desk.

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