Key risk is that the Fed is forced to deliver ‘deeper and faster’ cuts: Citi

Citi analysts highlighted a significant risk facing the Federal Reserve in a note Thursday: the potential necessity to implement “deeper and faster” interest rate cuts.

This assessment follows Wednesday’s Federal Open Market Committee (FOMC) meeting, where Chair Jerome Powell indicated that a rate cut is likely in September, provided inflation does not surge again.

The focus has now shifted to the labor market, where there is a steady increase in the unemployment rate. Citi projects 150,000 new jobs and a rise in the unemployment rate to 4.2% this Friday. Initial jobless claims, which have shown an uptick from their lows, are also being closely monitored.

“Markets have moved close to pricing our more-dovish-than-consensus policy path, but risks remain skewed toward deeper or faster cuts,” Citi said.

This dovish stance is predicated on the assumption that inflation will remain subdued, with core PCE inflation averaging below 0.25% month-over-month. If this condition holds, Citi said the Fed is expected to commence rate cuts in September, with the market currently pricing in about 70 basis points of cuts this year.

The bank’s note also mentioned a significant drop in two-year Treasury yields, which have fallen below 4.3% from about 5% in the spring. Despite this, Citi warns that Fed officials might need to exceed these anticipated cuts to stabilize the unemployment rate, which appears to be rising.

Citi analysts suggest that the Fed would need to cut rates back to a neutral level to maintain current labor market conditions. This neutral rate is estimated to be at least 100 basis points below current levels, implying rate cuts at the next four consecutive policy meetings.

If the labor market continues to weaken and inflation remains controlled, the investment bank believes it could lead to the consensus within the FOMC to implement 50 basis point cuts in one or more meetings.

Citi concludes that with two job reports due before the September FOMC meeting, a monthly payroll increase below 50,000 or an unemployment rate above 4.3% could significantly increase the likelihood of a 50 basis point rate cut in September.