"Inflation is the greater risk!" Citadel Securities urges the Federal Reserve to quickly shift towards a rate hike stance to avoid falling behind the situation.

As US inflation continues to rise driven by multiple factors, calls on Wall Street for a shift in Fed policy are increasing. Citadel Securities recently issued a clear warning, suggesting that the Fed should shift its focus from supporting employment to combating inflation and adjust its policy stance as soon as possible. "Inflation, not the labor market, is the bigger risk," said Nohshad Shah, head of fixed income sales for Citadel Securities in Europe, the Middle East, and Africa. "The Fed should take this seriously and adjust its stance quickly to avoid falling behind the situation." Since the outbreak of the US-Iran conflict, oil prices have risen significantly, leading to the largest inflation spike since 2023. Meanwhile, the stock market continues to rise under what Shah calls a "rare AI revolution", and with massive tech investment spending further fueling economic growth, US financial conditions have actually become more accommodative. Former New York Fed President Bill Dudley also recently warned that since the end of the pandemic, US inflation has remained above the 2% target, eroding the Fed's credibility as an inflation fighter. Indeed, recent economic data has confirmed this assessment. The US Consumer Price Index (CPI) rose by 3.8% year-on-year in April, exceeding market expectations of 3.7% and reaching a new high since May 2023; Core CPI rose by 2.8% year-on-year, also higher than expected. Producer Price Index (PPI) rose by 6% year-on-year in April, reaching a new high since December 2022. Inflation is being driven by multiple factors. The direct trigger is oil prices - international oil prices have been hovering around $100 per barrel due to disruptions in commercial shipping in the Strait of Hormuz. At the same time, the sticky price CPI tracked by the Atlanta Fed has an annualized year-on-year increase of 4.6%, with the core measure jumping to 4.8%, indicating that inflation pressures have deeply penetrated into areas such as rents and services. The mainstream market predicts that the year-on-year CPI in May may exceed 4%. Citadel's models show that the Fed's current interest rate levels are approaching neutral, neither stimulating nor inhibiting economic growth. Shah believes that this stance contradicts the market pricing reflecting expectations of "robust economic expansion". Expectations for rate hikes are heating up The change in inflation prospects has fundamentally altered the pricing of the Fed's policy path in the market. Interest rate swap markets indicate that rate hikes could possibly start as early as the end of October, with a 25 basis point hike at the beginning of next year almost fully priced in by the market. Trading participants on the prediction platform Kalshi believe that US inflation is almost certain to exceed 4% by 2026, with nearly a 40% chance of exceeding 5%. Meanwhile, since late February, concerns about inflation have escalated, causing bond yields to soar. Shah wrote, "The bond market is gradually realizing the fact that the economy is overheating and facing classic demand-driven inflation risks." Former Fed analyst and MacroStrat Insights director of US economics James Okafor said, "The market has experienced a drastic repricing, shifting from expecting rate cuts to expecting a hawkish stance to be maintained. Data is boxing the Fed into a corner. Even if economic growth slows down, they cannot cut rates in the face of accelerating inflation. This is a typical stagflation dilemma." Nomura Securities released a report on May 21, forecasting that the Fed will hold rates steady until 2026, with reduced likelihood of rate cuts in the short term. Nomura pointed out that the new Fed Chairman Kevin Wash might still lean towards easing monetary policy, but recent data and Fed officials' statements have raised doubts about whether Wash can convince a majority of FOMC members to support rate cuts. Collin Martin, head of fixed income research at JPMorgan Wealth Management, also pointed out that Wash may try to maintain a dovish stance, but "high inflation above 2% would make this difficult." Labor market concerns reemerge Shah also warned of potential risks in the labor market. The latest ADP weekly data shows that if the current pace of hiring in the private sector continues, it will be equivalent to adding 170,000 to 180,000 jobs per month, indicating signs of accelerating labor market. Of particular concern, Fed officials have recognized that due to tightened immigration controls, the threshold for maintaining the necessary "break-even growth in employment" to stabilize the unemployment rate may be close to zero. This means that if the current pace of job growth continues, there is a substantial risk of reigniting wage inflation. The minutes of the April FOMC meeting showed that "most" officials emphasized that if inflation remains above 2%, "modestly tightening policy" may be appropriate. This meeting recorded four dissenting votes, the highest since 1992, highlighting escalating internal disagreements. "The vast majority of officials pointed out that the time required to return inflation to the Fed's 2% target may be longer than previously expected, and this risk is increasing," the minutes read. Many officials are even leaning towards removing the language from the post-meeting statement hinting at a possible rate cut, shifting focus from "when to cut rates" to "whether to hike rates". Fed Governor Waller further signaled a hawkish stance in his speech on May 22. He said he would support removing the "accommodative bias" language from the policy statement, making the possibility of rate cuts equal to that of rate hikes. While Waller does not advocate for an immediate rate hike, he explicitly stated that if inflation does not begin to slow down quickly, "I cannot rule out the possibility of future rate hikes." Chicago Fed President Charles Evans, who was previously seen as dovish, has also shown a clear change in his stance. He said in mid-May, "Inflation is moving in the wrong direction, and this wrong development is not just limited to oil-related aspects." He specifically pointed out the worrisome unexpected rise in service sector inflation. Difficult start for the new chairman Kevin Wash officially took office as Fed Chairman on May 22. In his inauguration speech, he said he would lead a "reform-oriented" Fed, emphasizing fulfilling its duties of controlling inflation and achieving full employment with "independence, clear judgment, and steadfastness". However, the reality leaves him with very limited policy space. Senior economist at BMO Capital Markets Sal Guatieri commented, "The discussions at the April meeting suggest that FOMC's concerns about inflation prospects are escalating. The Fed currently has no plans for an immediate rate hike, but as long as inflation remains stubbornly high, the probability of rate hikes will continue to rise." David Russell, head of global market strategy at TradeStation, bluntly stated, "Rate hikes are back on the negotiation table. With Wash about to take office, the committee's stance is becoming more hawkish." Former President Trump has repeatedly called for rate cuts by the Fed, but in the face of rising inflation, he has recently softened his tone, implying that he will give Wash some policy room for maneuver. Shah believes that Wash faces the predetermined goal of "avoiding the start of a rate hike cycle", but the continuous rise in inflation is making this goal increasingly difficult to achieve. If the energy shock continues to transmit to a wider range of price behaviors, and the labor market continues to accelerate, rate hikes will become a choice that any Fed Chairman will find hard to avoid. "In this situation, it is difficult for any Fed Chairman to avoid the fate of rate hikes," Shah concluded.