In response to the impact of high oil prices, will the Federal Reserve not raise interest rates but instead "cut rates faster and more significantly"?

Ask AI · Why does Citigroup firmly believe that high oil prices won’t trigger Fed rate hikes?

When oil prices surge, the rate market puts “rate hikes” back on the table. Citigroup believes energy prices do push inflation risks higher and growth risks lower, but what’s more likely to change is “when to cut and how much,” rather than pushing the Fed back onto a rate-hike track.

According to the Pursuit the Wind Trading Desk, Andrew Hollenhorst, an analyst on Citigroup’s U.S. Economics team, said 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 ultimately soften the labor market, making rate cuts faster and/or deeper. “This sentence almost sets the frame for the entire piece: in the short term it’s driven by oil prices, but ultimately it still comes back to constraints from employment and growth.”

In their baseline scenario, energy prices fall over the next few months. The main change in the macro forecast is that in March and April, gasoline prices push “overall inflation” higher. The trouble with core inflation may begin with airfare (jet fuel) first, but the tougher part is that if the shock drags on, the transmission to core goods will narrow the window for rate cuts.

The biggest disagreement between Citigroup and the Fed isn’t about the inflation level, but about how to read the labor market: officials interpret the stability in the unemployment rate as “the balanced employment growth rate is close to zero,” while Citigroup believes this may be “residual seasonality” masking the loosening process—there has been a similar pattern over the past two years, with unemployment rates rising in spring and summer. On top of that, with higher gasoline spending and less-than-expected tax refunds, growth-side pressure may arrive earlier than what the market is currently pricing in.

The market is betting on rate hikes, but Citigroup is watching the path of “no change → bigger, faster rate cuts”

At the start of the report, they lay out a straightforward reality: as energy prices keep climbing and global central banks (including Powell) turn more hawkish in their wording, the rates market “aggressively” shifts pricing away from rate cuts and toward the possibility of rate hikes.

Citigroup’s rebuttal isn’t complicated: even if oil prices stay elevated for longer, the Fed may not need to use rate hikes to “chase” inflation. A more common combination is—out of inflation concerns, keep rates higher for longer, but high rates plus high energy costs will weigh on economic activity and increase the risk of downside pressure on employment, forcing the Fed to cut rates faster and/or deeper from a later position.

They place “rate-hike odds” within a very narrow set of conditions: only when energy prices are high and core inflation appears likely to stay above 3% will some officials argue for rate hikes; but even then, the committee is more likely to extend the “wait-and-see” stance rather than directly restart the rate-hike cycle.

Oil first lifts “headline inflation,” but it’s the tail-end transmission to core goods that really ties the hands of rate cuts

In the baseline scenario, Citigroup puts the bulk of the shock into gasoline prices in March and April: headline inflation will be passively pushed up, so they also raise their year-end headline PCE by about 0.5 percentage points.

On this core inflation line, Citigroup’s biggest concern is not “energy feeding directly into core,” but rather the jet fuel-driven faster rise in airfare prices. The bigger tail risk is that if the shock lasts longer, core goods will show a more noticeable transmission of energy costs, pushing back the timing when core goods inflation weakens.

Here they point to a detail: Powell has already mentioned at his press conference that even before the rise in oil prices, core goods inflation has been turning into a potential challenge to rate cuts. Citigroup further emphasizes that the core goods increase measured by the PCE basis looks more stubborn than CPI. They lean toward believing CPI is more reliable, because PCE may be boosted by an unusual upward surge in the prices of “computer software and accessories.” The Fed’s key assumption was that the core goods strength mainly comes from tariff cost pass-through and would cool around mid-year—if energy transmission drags that “strength” beyond mid-year, rate cuts would be more likely delayed.

“Stable” unemployment rate may not be good news: Citigroup is betting unemployment rises again in spring and summer

Citigroup admits their inflation forecasts don’t differ much from the Fed’s; but their judgment on employment is clearly more cautious. Officials stress that the unemployment rate is stable, implying the “balanced employment growth rate” may already be close to zero; Citigroup, however, thinks this stability may be the result of “residual seasonality”—a similar pattern showed up in 2024 and 2025: unemployment rates began rising in spring and summer.

This view directly affects policy projections: if the labor market is only “gradually loosening,” it becomes harder to imagine the Fed hiking rates because of rising oil prices. Conversely, once energy falls and unemployment starts to tick up within the year, the current “holding back cautiously” could quickly switch to calls for rate cuts.

They also add a “cushion”: both Powell and Waller have mentioned that longer-term inflation expectations remain stable. Citigroup’s interpretation is that this stability itself could become a reason to avoid rate hikes—and even support future rate cuts—even in scenarios with higher energy prices and higher inflation.

More expensive gasoline bills, fewer tax refunds: growth pressure may show up first in Q2

Citigroup provides a tangible quantification: consumers’ spending on gasoline will increase by about 30%. As long as energy prices stay high, on an annualized basis that amounts to roughly an additional $110 billion, or about $10 billion more per month. As a result, the year-over-year annualized growth rate of real GDP in Q2 may be dragged down by “a few tenths of a percentage point.”

More subtly, the tax refunds that many economists and some officials previously treated as a “tailwind” for consumption didn’t materialize as expected. Compared with the market’s expectations that tax refunds related to the《One Big Beautiful Bill Act (OBBBA)》could increase by $100 billion to $150 billion, Citigroup sees the outcome as closer to only about $30 billion to $40 billion higher (their own forecast is about $50 billion).

The report also acknowledges that higher oil prices may bring more oil and gas investment, offsetting some weakening in consumption; but as of now, the number of active drilling rigs hasn’t risen, suggesting producers are treating this shock as “more short-term” and haven’t started ramping up production.

Powell and Waller’s “more hawkish” tone is mostly about buying time rather than changing direction

Citigroup characterizes the communication after this FOMC as: before the meeting, they thought the risks were more dovish, but Powell’s wording was more hawkish than expected. On the surface, the SEP’s “dot plot” still points to a median path of one 25bp cut this year, even with core and headline inflation forecasts revised upward; but Powell’s concern about the labor market isn’t as heavy as the market imagines, and he hasn’t strongly pushed back against the idea that “higher inflation may limit the scope for rate cuts.”

Waller’s change is more concrete: he didn’t vote against immediate rate cuts as some people had guessed; instead, he chose “caution” consistent with the consensus. He later explained that if there were no rise in oil prices, a February employment decline of 92,000 would have been enough for him to support a 25bp rate cut; now he views the rise in energy prices as more likely to be “more persistent,” so it requires waiting. But he left a back door: if the labor market weakens, or if the rise in energy prices is proven not to be persistent, he would likely return to supporting rate cuts.

On the policy path, Citigroup’s baseline scenario is still “total 75bp of rate cuts this year.” Their interest rate projection table shows: stay put in April, cut 25bp in June, 25bp in July, and 25bp in September; the policy range is cut to 2.75%-3.0% by September, then pauses.

What to watch next week: oil prices and officials’ remarks may change pricing more than the data

Citigroup reminds that in the short term, the market will still be driven by oil prices and geopolitical developments, which will keep rate-market pricing diverging sharply from their policy judgment. They expect some officials to push back against the market’s pricing for “rate hikes this year,” at least to some degree—especially more dovish figures like Daly and Paulson; and the remarks by Deputy Chair Jefferson, who is closer to the middle of the committee, are also worth closely watching.

On the data front, Citigroup expects the S&P PMI to still show a modest expansion, but the factory input price index may draw more attention given the impact of oil prices; initial jobless claims remain low and they expect a slight uptick; construction spending is expected to continue growing modestly. But the subtext of this weekly report is: these data are more like background noise—the true “rhythm-makers” are still energy prices and how the Fed tells the story.