Will the Fed raise interest rates in October? Employment data is unlikely to change expectations; the key will be the next CPI report.

The direction of the Federal Reserve's October policy meeting is increasingly dependent on a set of inflation data.

According to TrendFocus, a new report released by Citigroup Research on September 28th pointed out that the Federal Reserve's policy response function has become more sensitive to immediate inflation data and energy prices . Even if the upcoming employment data is lower than expected, it will be difficult to substantially shake the market's pricing of a more than 50% rate hike in October. The final decisive factor will be the September core CPI reading.

The bank expects nonfarm payrolls to increase by about 85,000 in September, with the unemployment rate rising slightly from 4.1% to 4.2%. Citigroup Research economists Andrew Hollenhorst and Veronica Clark believe that this result is insufficient to significantly lower market pricing in an interest rate hike; only extreme scenarios such as negative nonfarm payrolls or an unemployment rate rising to 4.3% would likely prompt the market to reassess the probability of an interest rate hike.

Meanwhile, Citigroup expects a significant downward revision to the core PCE inflation data to be released this Wednesday, leaning towards a dovish stance. However, since the market has already anticipated this, the actual impact is expected to be quite limited. This means that the suspense surrounding whether or not there will be an interest rate hike in October will focus on the single data point of the September core CPI, highly similar to the situation before the September policy meeting.

High thresholds for employment data make it difficult to reverse expectations of interest rate hikes on their own.

The report recalls that prior to the September policy meeting, Federal Reserve Governor Waller stated that he would support maintaining the current interest rate as long as the August inflation data was favorable. However, the August core CPI rose 0.3% month-on-month, higher than the market expectation of 0.2%, ultimately prompting a market repricing, and the Federal Reserve followed suit, implementing a 25 basis point rate hike.

This process clearly reveals the current decision-making logic of the Federal Reserve: with the job market still resilient and inflation yet to clearly decline, monthly CPI readings have the power to influence policy direction.

Citigroup points out that the market has already priced in a greater than 50% probability of an October rate hike. Based on this, if employment data is close to expectations, its marginal impact on rate hike expectations will be very limited.

The bank believes that only two scenarios could substantially alter market pricing: negative non-farm payrolls or a jump in the unemployment rate to 4.3%. While not impossible, these are not benchmark expectations. In other words, the jobs report is more likely to be data that "doesn't change the conclusion," and the market and officials will immediately turn their attention to inflation.

September core CPI: A key variable determining the October interest rate hike

Citigroup believes that the September core CPI reading may be weak, with a month-on-month increase of 0.2% or lower. There are two reasons for this: first, persistent sub-items such as housing have shown signs of slowing; second, the strength of the August core CPI was partly due to volatile sub-items such as mobile phone service packages, and the sustainability of these factors is questionable.

If the core CPI cools down as expected in September, it will provide a basis for some officials who are inclined to pause interest rate hikes. Most Fed officials project a total of 50 basis points in the dot plot this year, and given that the potential impact of the sharp rise in Treasury yields on the economy remains to be seen, some officials were already inclined to hold rates steady at this time.

The core PCE data to be released this Wednesday will be revised significantly downward, indicating a dovish policy stance. However, the bank also emphasizes that since this downward revision is already priced in by the market, its actual impact on the Fed's policy path and market pricing is expected to be quite limited.

This assessment further reinforces Citigroup's core conclusion: with employment and PCE data unlikely to significantly alter the overall picture, the outcome of the October policy meeting will be highly focused on the single variable of the September core CPI, and investors should pay close attention to the timing and reading of this data release.

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