Facing high oil prices impact, will the Fed not raise rates but instead cut rates "faster and by larger margins"?

Wall Street Insights

Citigroup believes the Federal Reserve is unlikely to be pushed back onto a rate-hiking path by energy prices. The more probable scenario is “holding steady longer → then cutting rates more quickly and deeply.” Short-term gasoline bills are eating into consumer spending, tax refunds are below expectations, and unemployment may rise again in spring and summer—growth pressures could arrive earlier than markets anticipate. Citigroup’s baseline scenario remains a total of 75 basis points of rate cuts this year, with no change in April, followed by 25 basis point cuts in June, July, and September.

When oil prices surge, the interest rate market quickly shifts focus back to rate hikes. Citigroup believes energy prices do push inflation risks upward and growth risks downward, but they are more likely to influence “when and how much to cut,” rather than forcing the Fed back onto a rate-hiking trajectory.

According to ChaseTrade, Andrew Hollenhorst, an analyst on Citigroup’s US economic team, states in a recent report that rate hikes are unlikely… Rate cuts may be delayed due to inflation concerns, but tighter financial conditions and higher energy costs will eventually soften the labor market, leading to faster and/or deeper rate cuts. This nearly sets the framework for the entire outlook: short-term driven by oil prices, ultimately returning to employment and growth constraints.

In their baseline scenario, energy prices are expected to decline over the coming months. The main macro forecast change is that gasoline prices in March and April will push “overall inflation” higher; the trouble with core inflation may start with airfare (jet fuel), but a more complex issue is that if shocks prolong, the transmission to core goods could narrow the window for rate cuts.

The biggest disagreement between Citigroup and the Fed isn’t about inflation levels but about the interpretation of the labor market: officials interpret stable unemployment as “balanced employment growth near zero,” while Citigroup believes this may be “residual seasonal effects masking loosening”—a pattern seen in spring and summer unemployment increases over the past two years. Coupled with rising gasoline expenses and below-expected tax refunds, growth pressures may arrive earlier than currently priced in by markets.

Markets are betting on rate hikes, but Citigroup is focused on a path of “holding steady → then more aggressive rate cuts.”

The report begins with a reality check: as energy prices continue to rise and global central banks (including Powell) adopt hawkish tones, the interest rate market is “sharply” pricing in the possibility of rate hikes rather than cuts.

Citigroup’s counterargument is straightforward: even if oil prices stay high longer, the Fed may not need to hike rates to “chase” inflation. A more common scenario is—due to inflation concerns—keeping rates elevated longer, but high rates plus high energy costs will slow economic activity and increase downside risks to employment, eventually prompting the Fed to cut rates faster and deeper from a later point.

They narrow the “likelihood of rate hikes” to a very specific set of conditions: only if energy prices remain high and core inflation appears likely to stay above 3%, some officials might advocate for hikes; but even then, the committee is more likely to extend the pause rather than restart a rate hike cycle.

Oil prices initially push up “overall inflation,” but the real obstacle to rate cuts is the transmission of energy costs into core goods.

In their baseline scenario, the main impact is on gasoline prices in March and April: overall inflation will be passively lifted, leading them to raise the year-end overall PCE inflation forecast by about 0.5 percentage points.

Regarding core inflation, Citigroup’s current concern isn’t “energy directly entering core,” but rather the faster rise in jet fuel prices affecting airfare. The bigger tail risk is that if shocks prolong, energy costs will more significantly feed into core goods, delaying the decline in core inflation.

They highlight a detail: Powell mentioned in the press conference that even before oil prices rose, core goods inflation was becoming a potential challenge to resuming rate cuts. Citigroup emphasizes that PCE-based core goods inflation appears more persistent than CPI; they tend to trust CPI more because PCE may be inflated by abnormal increases in “software and accessories” prices. The Fed’s original key assumption was that core goods inflation, driven mainly by tariff pass-through, would cool around mid-year—if energy transmission prolongs “above trend” past mid-year, rate cuts could be further delayed.

Unemployment “stability” may not be good news: Citigroup bets on a rise again in spring and summer.

While acknowledging that inflation forecasts are not far from the Fed’s, they are notably more cautious about employment. Officials emphasize stable unemployment, implying “balanced employment growth” may have already slowed to near zero; Citigroup believes this stability could be “residual seasonal effects”—a pattern seen in 2024 and 2025, with unemployment rising again in spring and summer.

This judgment directly influences policy projections: if the labor market is “loosening slowly,” it’s harder to imagine the Fed raising rates due to rising oil prices; conversely, if energy prices fall and unemployment rises within the year, the current “cautious hold” could quickly shift toward rate cuts.

They add a “buffer”: Powell and Waller both mentioned that long-term inflation expectations remain stable. Citigroup interprets this stability as a reason for “not raising rates, and even for future rate cuts”—even in scenarios with higher energy prices and inflation.

Higher gasoline bills and fewer tax refunds: growth pressures may emerge in Q2.

Citigroup quantifies this: consumer spending on gasoline could increase by about 30%. As long as energy prices stay high, this could amount to roughly $110 billion annually, or about $10 billion per month. As a result, Q2 real GDP growth could be dragged down by “a few tenths of a percentage point.”

More subtly, the expected tax refunds related to the “One Big Beautiful Bill Act (OBBBA)”—which many economists and officials saw as a boost to consumption—may fall short. Instead of the anticipated $1 trillion to $1.5 trillion increase, Citigroup sees only about $300 billion to $400 billion (their own forecast is around $500 billion).

The report also admits that high oil prices could spur more oil and gas investment, offsetting some consumption weakness; however, so far, drilling activity has not increased, suggesting producers view this shock as “short-term” and have not yet expanded capacity.

Powell and Waller’s “hawkish tilt” is more about delaying than changing course.

Citigroup characterizes the post-FOMC communication as: before the meeting, they thought risks leaned dovish, but Powell’s tone was more hawkish than expected. The SEP’s “dot plot” still shows a median of one 25bp rate cut this year, despite upward revisions to inflation forecasts; however, Powell’s concerns about the labor market are less severe than markets imagine, and he did not strongly oppose the idea that “higher inflation could limit rate cuts.”

Waller’s stance is more concrete: he did not vote against an immediate rate cut, as some speculated, but aligned with consensus in favor of “caution.” He explained that if oil prices hadn’t risen, a decline of 92,000 jobs in February would have been enough for him to support a 25bp cut; now, he sees the more persistent energy rise as requiring patience. But he left a backdoor: if the labor market weakens or energy prices prove less persistent, he would likely support rate cuts again.

On the policy path, Citigroup’s baseline remains “a total of 75bp cuts this year.” Their rate forecast shows: hold steady in April, then cut 25bp in June, July, and September, bringing the policy range to 2.75%-3.0% by September, then pause.

Next week’s focus: oil prices and officials’ statements, which may influence markets more than data.

Citigroup warns that short-term markets will continue to be driven by oil and geopolitical developments, causing rate market pricing to “diverge sharply” from their policy outlook. They expect some officials—especially more dovish ones like Daly and Paulson—to counteract market expectations of rate hikes this year. Meanwhile, statements from Vice Chair Jefferson, who is closer to the middle of the committee, are also worth watching.

On the data front, Citigroup expects the S&P PMI to still show moderate expansion, but input prices in manufacturing may attract more attention due to oil’s influence; initial jobless claims are expected to remain low but slightly rise; construction spending is forecast to continue modest growth. However, the underlying message of this weekly report is that these data are more background noise—the real “drivers” are energy prices and how the Fed narrates the story.

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