Citigroup forecasts that a "dovish surprise" from the Federal Reserve is brewing, with core inflation approaching 2% as the key.

Citi believes that if the short-term growth rate of core PCE continues to hover near the 2% annualized level, the tightening path after the September rate hike may shift. The key question is whether the Fed’s previously expected subsequent rate hikes will still materialize, rather than an immediate pivot to rate cuts. Citi economist Andrew Hollenhorst noted in a report that the U.S. economy is not overheated, adding that “we have not seen strong grounds for further rate hikes.” The September meeting minutes revealed that at least some officials also did not judge the economy as clearly overheated, but agreed to raise rates based on risk management amid upside inflation risks. This means if underlying inflation continues to cool, the preventive justification for the September rate hike could quickly fade. Most officials still expect a possible additional rate hike before year-end, but the minutes show no urgency for a consecutive October rate hike. Citi prioritizes core PCE month-on-month data over the still-high year-on-year figure: August core PCE rose 0.2% month-on-month, July was revised to 0.1%, and August year-on-year rose 3.0%. If it runs at an annualized rate of around 2% for several consecutive months, inflation would be seen as falling at the “sufficient pace” required by the Fed. Citi also remains cautious about energy shocks passing through to core inflation, arguing that companies have not yet broadly passed on energy costs to core prices. Its baseline scenario projects core inflation to stay low over the next four months, and flags downside risks to September core inflation. A so-called “dovish surprise” would likely mean the rate hike cycle ends earlier than the dot plot and market expectations, rather than a rapid shift to rate cuts. Fed Chair Jerome Powell has not yet clarified the standard for “sufficient pace”; an annualized core PCE rate of around 2% over several consecutive months can serve as a reasonable reference.