Citi Research25 September 2026

A more hawkish reaction function

US Economics Weekly

We were neither expecting the sharp rise in energy prices nor the Fed’s increased willingness to react to them with higher interest rates. A reaction function that includes energy prices means risks skew hawkish in the near-term and make it hard for the market to price-out aggressive rate hikes until data convincingly show either slowing inflation or softening activity. That dynamic took Treasury yields meaningfully higher this week. But fundamentally, we see underlying inflation cooling. Higher long-term interest rates should slow growth and loosen labor markets. In our base case, the Fed will pursue significantly less hawkish policy than what is currently priced by the market.

Andrew Hollenhorst · Veronica Clark下载原始 PDF

In late August, the market had largely priced-out Fed rate hikes for this year. Oil prices were off their highs and two months of data showed cooler core inflation and slower payrolls growth. But the situation has changed materially since that time and markets now price an additional ~100bp of hikes beyond the 25bp delivered last week. Ten-year Treasury yields increased by about 20bp on the week, reaching a multi-year high of 5.2%.

A bar chart of cumulative policy rate hike pricing by Federal Reserve meeting, with the market priced policy rate on a second scale.

A time series chart comparing the two-year Treasury yield with diesel prices.

At least three factors have pushed yields significantly higher over the last month.

1) Energy prices have increased. Diesel prices, an important factor in transportation costs, have reached new highs.

2) The last month of US economic data show resilient growth (including this week’s PMI), a stable labor market, and above-target inflation.

3) Chair Warsh and the committee expressed a considerably more hawkish reaction function which will now directly react to, rather than “look through” supply-side shocks.

In our view, it is development (3) that is most important in explaining the rise in Treasury yields as higher energy prices appear to now directly enter the Fed’s reaction function. Cleveland Fed President Hammack summarized the view that due to the multi-year overshoot, interest rates must become more reactive to supply shocks:

“The conventional view is that monetary policy should look through a supply shock but when the environment is more prone to shocks, or the shocks arrive one after another in a period when inflation has been elevated for years, there’s a greater risk that an inflationary mindset could take hold”

Until there is a reversal in one or more of the three key drivers, there will be no reason for Fed officials to sound less hawkish or for markets to price a more dovish policy path. It is unlikely that the Fed’s reaction function – which has now been established as more hawkish, would shift significantly in the near term.

We – and most other observers – continue to expect oil prices and broader energy prices to fall significantly at some point in the next year.

By our analysis, most measures of “underlying” inflation are slowing and not too far off from target. Core CPI at 2.4%YoY – just 0.1pp above its pre-pandemic norm – is a prime example. But Fed officials appear to be watching other indicators to determine whether or not inflation is slowing at an acceptable pace. Core PCE itself remains elevated and even after downward revisions will finish the year running at close to 3%. “Supercore” inflation (core services ex-shelter) is elevated on higher airfares and (in PCE) higher equity prices that feed into “portfolio management fees.”

A line chart comparing year-over-year core PCE and core CPI inflation from 2015 to 2026.

A line chart comparing CPI and PCE core services inflation, excluding shelter, from 2018 to 2026.

Base effects alone mean there is a low bar for year-on-year inflation readings to continue to cool. And given the (in our view) encouraging underlying trend, core measures should also continue to come in cooler in coming months. Even accounting for “residual seasonality” in January and February, we think inflation will have cooled sufficiently to have the Fed cutting in mid-2027.

But that story will take months to play out in the data. The only near-term driver of more dovish pricing would be a slowing in economic growth. Data this week reinforced that the economy was solidly expanding before interest rates and energy prices increased. PMI indices were stronger than expected with services rising to 58.7 from 56.5 and manufacturing up to 57.0 from 53.9. Core capital goods orders rose a strong 1.6%, consistent with a manufacturing sector that is holding up well.

The housing sector, which is already in contraction, is most interest rate sensitive and likely will be the first place where a slowdown is apparent in the data. In coming months, we expect a further decline in single-family housing starts. A significant overhang of inventory will put downward pressure on house prices.

A dual-axis chart comparing 30-year fixed mortgage rates with single-family building permits.

A line chart of year-over-year mortgage applications for purchase from 2021 to 2026.

It will likely take longer to see the effect of higher interest rates on the labor market. When the Fed raised policy rates aggressively in 2022, it took about six months before the labor market responded. On the margin, higher borrowing costs for firms will damp demand for new workers, keeping hiring rates at historically low levels. While the labor market has been “stable” in the sense that the unemployment rate has remained steady around 4.1%, the sharp drop in the participation rate and difficulty in finding a job do not make the labor market as immune to rate hikes as Chair Warsh has suggested.

A chart comparing the unemployment rate with the share of respondents who say jobs are hard to get.

A bar and line chart of monthly nonfarm payroll growth and its three-, six- and twelve-month averages.

Next Week—Focus turns to inflation and labor market data

Next week’s focus will be on September payrolls and August PCE inflation data. We expect payroll growth to slow to 85k after August’s surprisingly strong 162k gain, with ongoing volatility and potential revisions continuing to complicate the labor market signal. While jobless claims remain very low, underlying job growth is likely being restrained by a smaller labor force as immigration slows and population aging continues. We think wage growth will be an increasingly important variable to watch for signs of any retightening in the labor market. Average hourly earnings modest at 3.1% in September would not suggest this is the case.

On inflation, we expect core PCE to rise 0.3% MoM, but the more important development will be annual revisions. We expect revisions to lower core PCE inflation by roughly 30bp, leaving core PCE around 3.1% YoY in August. While still stronger than other underlying inflation measures, revisions could leave inflation running below the Fed’s latest projections.

Spending in August should be strong in line with a rebound in retail sales from a weak July. Annual GDP revisions will also impact activity and income data for the past five years. These revisions also have potential to impact current-quarter estimates of Q3 GDP (Atlanta Fed GDPNow stands at 5.0%). Advance release trade data could also have significant implications for Q3 GDP.

Veronica Clark

Nonfarm Payrolls: Citi: 85k, median: 100k, prior: 162k
Private Payrolls: Citi: 70k, median: 90k, prior: 127k
Manufacturing Payrolls: Citi: 10k, median: 10k, prior: 16k

After a surprisingly large jump in August, we expect nonfarm payroll employment to moderate with a still-solid 85k jobs in September. But we would continue to highlight that monthly volatility and possible revisions to payrolls are both likely to remain larger than usual. We still expect average job growth to remain soft throughout the year, reflecting a smaller labor force.

We would see risks around September payrolls as mostly two-sided, but do expect some payback from strong August either through revisions or upcoming weakness in some month. One issue is that the seasonal adjustment of August payrolls looked abnormally strong. Over the year, cumulative seasonal adjustment factors should be close to zero (some months are adjusted higher, some months lower). But so far, cumulative seasonal adjustment in 2026 is running about 100k stronger compared to last year. This would suggest some offsetting weakness in some upcoming month. Additionally, leading survey data such as NFIB hiring plans suggest some near-term weakness before possibly stronger payrolls at the end of the year.

Still, September labor market data have been solid, with low initial and continuing jobless claims suggesting low layoffs and some possible increase in hiring. But to the extent that low claims reflect a smaller labor force, low claims may not necessarily be associated with stronger payrolls. At a sector level, there may still be some strength in government employment, as education employment rebounds from the summer months after the restart of the school year (likely impacted by bad seasonal adjustment). Manufacturing employment and some subsectors of construction employment may also remain strong due to AI-investment demand.

A bar and line chart of monthly nonfarm payroll growth and its six-month average from 2024 to 2026.

A line chart of year-over-year average hourly earnings compared with its 2019 average.

Average Hourly Earnings MoM: Citi: 0.2%, median: 0.3%, prior: 0.3%
Average Hourly Earnings YoY: Citi: 3.1%, median: 3.2%, prior: 3.1%

We expect a modest 0.2%MoM increase in average hourly earnings in September, with the year-on-year measure remaining at 3.1%. Average hourly earnings have slowed over the course of this year, falling back to a typical pre-pandemic pace. Over the next few months, base effects are particularly favorable for further slowing in AHE as stronger readings from last year will drop out of the 12-month period. These stronger readings in October/November 2025 may have been boosted by reduced hours worked (the denominator of AHE) around the government shutdown. Slowing in wage growth and somewhat softer payrolls compared to August strength should keep income growth modest in nominal terms and particularly soft in real terms as gas prices rise in September.

We think wage trends will become increasingly important over the coming months for assessing any tightening in the economy outside of strong investment and rising asset prices. Markets could be sensitive to average hourly earnings as an early signal of wage trends. With the risk of softer AHE over the next ~3 months (in year-on-year terms, see above), this can be one factor helping to reduce pricing of rate hikes this year. Ultimately, wage measures like the employment cost index and the Atlanta Fed’s wage tracker will be most important for most Fed officials. Most forward-looking signals we track suggest these wage measures moving sideways at typical pre-pandemic rates.

Unemployment Rate: Citi: 4.2%, median: 4.1%, prior: 4.1%

After remaining at 4.1% for the last two months, we expect a slight increase in the unemployment rate to 4.2% in September. At 4.14% in August, the unemployment rate was already very close to rounding to 4.2%. We expect the slight uptick in unemployment to be accompanied by another modest increase in the labor force participation rate. Residual seasonality the last few years has generally implied a modestly higher participation rate late in the summer when school restarts, offsetting declines earlier in the summer. We do think some of the decline in participation earlier in the year reflected these seasonality issues.

But rather than residual seasonality, the more overwhelming force impacting the labor market data this year (particularly the labor force participation rate) seems to be demographic changes of slowing immigration and an aging population. Participation is unlikely to fully rebound to levels of the last few years.

Leading signals for the unemployment rate in the near-term are mixed, with some survey data still suggesting upside risk. On the other hand, there remains the possibility that the labor force continues to shrink and unemployment falls further. Initial and continuing jobless claims have been at very low levels all year and continue to fall. But we would note that without stronger wage growth, a lower unemployment rate is not necessarily a sign of a tightening labor market. Rather, the demographic forces that have put downward pressure on unemployment (aging population, slowing immigration), would imply a lower NAIRU.

A chart comparing the unemployment rate with a survey measure of respondents who say jobs are hard to get.

JOLTS Job Openings: Citi: 7380k, median: 7225k, prior: 7271k

We expect a rebound in JOLTS job openings to 7380k in August but with high frequency data on job postings from Indeed.com suggesting openings largely continue to move sideways around 7-7.5 million in coming months.

We continue to think that rather than the level of openings themselves, details of labor market flows from the JOLTS report are the more useful signals for labor market dynamics. Given strong payroll job growth in August, there should either be an increase in hiring in JOLTS data (more positive signal for stronger labor market) or a decline in separations like layoffs or quits (a slightly less positive signal). If the difference in August hires less separations is not quite as strong as 162k August payrolls, there could be revisions lower to August payrolls and/or weaker September job growth.

While the level of JOLTS openings is not necessarily a useful signal of demand for workers, changes in openings could be a reflection of whether demand is picking up or not. So far, demand seems stable and moving sideways. But the trend of job openings could be an increasingly important signal, especially as the ratio of job openings to unemployed workers tends to lead trends in wage growth by a few months. We think wages will increasingly become an important sign for markets and Fed officials for whether the economy broadly is tightening and requires higher policy rates to cool demand (beyond rising asset prices and strong AI investment).

A chart comparing the job openings to unemployed workers ratio with the Atlanta Fed wage tracker.

PCE Price Index MoM: Citi: 0.3%, median: 0.4%, prior: 0.2%
PCE Price Index YoY: Citi: 3.5%, median: 3.7%, prior: 3.7%
Core PCE MoM: Citi: 0.3%, median: 0.3%, prior: 0.2%
Core PCE YoY: Citi: 3.1%, median: 3.3%, prior: 3.3%

Core PCE should rise 0.29%MoM in August, a similarly strong increase as in core CPI with a boost from factors like education services and wireless services. Core goods prices should also rise modestly, with slowing in housing services as shelter inflation details from CPI were soft. Airfares continue to rise with higher jet fuel costs.

But there is much more uncertainty around August PCE than usual due to annual revisions and methodological changes to key components. For the month of August specifically, we estimate new methodologies will add around 4bp to core PCE. We are penciling in a 0.5% decline in each of portfolio management services and computer software and accessories. CPI computer software and accessories fell by more in August, although we suspect certain PPI components will comprise a much larger share of the PCE computer software index. PPI portfolio management fell by more in August, but it is very unclear how this component in PCE will change with its new methodology, especially on the initial release of monthly PCE data.

We expect core PCE to rise 3.14%YoY in August, incorporating revisions to the last five years of data. This downward revision of about 30bp would be very close to the 3.2%YoY estimate that Chair Warsh mentioned for August core PCE in his opening remarks of the September FOMC press conference (an estimate presumably from the Fed staff). Headline PCE should see similar 20-30bp downward revisions.

Headline PCE should rise 0.34%MoM, rounding to 0.3% but close to 0.4%. Year-on-year PCE should rise 3.5% also with downward revisions.

A stacked bar chart of the contributions to the difference between new and old core PCE readings.

Personal Income: Citi: 0.5%, median: 0.5%, prior: 0.4%
Personal Spending: Citi: 0.7%, median: 0.9%, prior: 0.2%

Income and spending should be strong in August, although with more uncertainty this month over the recent trend of consumption and income given annual revisions incorporated with August data. We expect a solid 0.5% increase in personal income and a strong 0.7% increase in spending, with strength led by goods spending. Retail sales rebounded strongly in August from a decline in July, with the average increase in spending over the two months still solid. But as real income growth remains soft with high gas prices, further upside to spending could be limited. Much of the recent strength in services consumption however has likely not been impacted by softer incomes. Strong consumption of health care services would largely not be paid for by consumers directly (instead paid by insurance or the government).

A stacked bar chart showing monthly contributions to personal consumption expenditures by category.

The savings rate should decline again in August, although with uncertainty around the recent trajectory of savings. In recent years, annual revisions have implied higher income than previously estimated and thus higher savings. We think large upward income revisions are less likely this year as immigration has slowed, and previous revisions may have been related to undercounting of new immigrants. Revisions to real consumption, however, could be slightly higher as we expect PCE inflation to be revised lower (possibly implying stronger consumption).

ISM Manufacturing: Citi: 55.2, median: 55.0, prior: 54.6

ISM manufacturing should rise to 55.2 in September from 54.6 in August, signaling continued strength in the manufacturing sector. A very strong increase in the S&P manufacturing PMI in September could suggest upside risks, but various regional manufacturing indicators, while still strong, did not increase quite as much as PMI. We typically take more signals on manufacturing activity from the ISM survey than PMI. For example, ISM manufacturing employment tends to correlate more closely with manufacturing payrolls and has been stronger than PMI employment for a few months, suggesting still-strong manufacturing job growth. AI investment demand will likely continue to support manufacturing activity into next year, although some non-AI activity could increasingly face headwinds from higher rates and fading fiscal support.

A chart comparing manufacturing employment changes with ISM and PMI employment measures.

Conf. Board Consumer Confidence: Citi: 87.7, median: 90.0, prior: 89.4

We expect the Conference Board’s consumer confidence measure to fall further in September to 87.7, alongside similar weakening in the University of Michigan survey in September. Weaker consumer confidence could be a reflection of rising gas prices, and stands in contrast to strong business survey data in September such as PMI indices. Details of the Conference Board measure in particular however could be useful for gauging labor market risks. In August, consumers did perceive better hiring conditions with an improvement in the labor market differential (the share saying jobs are plentiful less the share saying jobs are hard to get). This corresponded with stronger payroll job growth in August. Continued improvement in sentiment around the labor market could signal stronger employment data. However, sentiment around the labor market still seems softer than hard data suggest, with an elevated share of consumers saying jobs are hard to get still implying upward risks to the unemployment rate.

A chart comparing the Conference Board jobs hard to get measure with the unemployment rate.

S&P Case Shiller 20-City MoM SA: Citi: 0.27%, median: 0.20%, prior: 0.24%
S&P Case Shiller 20-City YoY NSA: Citi: 2.00%, median: NA, prior: 2.10%
S&P Case Shiller US HPI YoY NSA: Citi: 1.49%, median: NA, prior: 1.52%

Case Shiller home prices, our preferred monthly measure of home prices, should rise modestly on the month in July and continue to rise around 1-2%YoY, softer than a typical pre-pandemic pace of home price appreciation. Some modest pick-up in median home prices recently could reflect sales of more expensive homes, suggesting that Case Shiller prices, which will control for the quality of homes sold, could remain more modest. With mortgage rates rising substantially again, some high frequency data have recently started to show renewed slowing in housing activity. Indeed, recent weekly data on home prices suggest the previous pick-up in prices may have stalled. We expect higher rates to keep home prices soft through the rest of this year.

A chart of median sale prices and year-over-year home price appreciation from 2023 to 2026.

Advance Goods Trade Balance: Citi: -$119.3b, median: -$113.9b, prior: -$118.9b

The goods trade balance should continue to widen further in preliminary August data, to -$119.3 billion with increases in both exports and imports. This could partly reflect renewed increases in commodity prices pushing up nominal trade flows. There is still some modest downside risk to industrial supplies exports from a further pullback in gold exports, but trade in gold should not impact GDP growth. We expect strength in imports to remain driven by strong capital goods imports, although these could moderate slightly in August after a surge in July. Overall capital goods imports in Q3 should remain very strong, signaling still-strong business equipment investment in GDP driven by AI-demand.

A chart comparing capital goods imports with real business equipment investment in information processing equipment.

Construction Spending: Citi: -0.1%, median: 0.1%, prior: -0.5%

We expect another decline in overall construction spending in August of 0.1%MoM, with weakness continuing in residential construction. While single family housing starts rebounded in August, construction spending on single family residential units tends to follow starts with a lag and will likely decline again. As homebuilder sentiment has already started to decline with higher mortgage rates, we expect permits and starts of single family units to pullback further in coming months. This should keep residential construction spending, a direct input into residential investment in GDP, soft. Outside of residential construction, construction of most other projects remains weak. Spending on building of data centers remains strong, but most other categories of construction spending continue to decline. This partly reflects weak spending on building of manufacturing facilities as CHIPS act spending that was very robust a few years ago continues to fade. Construction of many projects other than rate-insensitive data centers could face headwinds from higher borrowing costs.

A chart comparing single-family housing starts with single-family residential construction spending.

Initial Jobless Claims: Citi: 203k, median: NA, prior: 197k
Continuing Claims: Citi: 1725k, median: NA, prior: 1719k

Initial and continuing jobless claims have been very low throughout the year but have fallen to even lower levels in recent weeks following the Labor Day holiday. We expect initial claims to rise modestly to 203k the week of September 25 and continuing claim to rise to 1725k the week of September 19. If continuing claims remain at very low levels, this could suggest a renewed decline in the unemployment rate within a few months. While continuing claims should correspond more concurrently with labor market conditions in the monthly employment reports, recent patterns have implied continuing claims leading the unemployment rate.

Some of the decline in continuing claims could reflect increased hiring, but could also just reflect that initial claims have been very low (fewer flows onto unemployment insurance in the first place). Ultimately, the path of wage growth will be key indictor for whether lower unemployment reflects a retightening of the labor market. So far this year, we think the most overwhelming driver of low claims is an overall smaller labor force given slowing immigration and an aging population. To the extent that these large demographic shifts also mean a lower natural rate of unemployment, lower unemployment would not necessarily reflect a tightening labor market that is creating upward pressure on prices and wages.

A chart comparing continuing jobless claims with the unemployment rate.

Fed Monitor

A table ranking FOMC members from hawkish to dovish and listing their positions, voting years and term expiration years.

A table grouping Federal Reserve officials by their apparent position in the June FOMC dot plot.

A table of Citi's policy rate forecast by Federal Reserve meeting through December 2027.

GDP Tracking

We expect a 1.8% increase in Q3 2026 real GDP.

A chart showing quarterly real GDP growth and contributions by expenditure category.

A table comparing Citi's Q3 2026 GDP forecast and contributions with the Atlanta Fed estimate.

Inflation Forecasts

A monthly table comparing market pricing with Citi forecasts for CPI and PCE inflation from September 2026 to September 2027.

A line chart comparing Citi's CPI forecast with market pricing through September 2027.

A line chart of one-year, one-year and five-year, five-year inflation swap rates from 2025 to 2026.

A table of Citi's economic forecasts for 2026 and 2027, including quarterly estimates.

Appendix A-1

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