Citi expects hawkish Fed to slow non-AI economy

Citi Research, in a recent report, warned that the Federal Reserve's recent interest rate hike could have severe consequences for the U.S. economy. The central bank increased its policy target range by 25 basis points to 3.75%-4%, signaling a shift towards a more hawkish stance. Fed Chair Kevin Warsh explicitly connected this move to rising energy costs and hinted at further tightening, stating that the decision demonstrated the seriousness of the situation.

Citi's baseline forecast anticipates that inflation will remain under control, meaning the Fed will likely maintain its current policy for several months before any cuts begin. However, analysts cautioned that the likelihood of another rate hike - possibly as early as October - has increased following Warsh's hawkish comments. This has led to a tightening of financial conditions for both businesses and households.

While Citi noted that the rising interest rates and longer-term Treasury yields have tightened the financial environment, they emphasized that this tightening cycle will have little impact on the primary driver of U.S. economic growth: investment in artificial intelligence (AI). The analysts stated that tighter monetary policy will not substantially slow the tailwind to growth from AI-related capital expenditure, provided there is no market correction or widening corporate credit spreads to impede capital flows to technology giants.

On the other hand, non-AI sectors are expected to face increasing pressure. The housing market, in particular, is likely to contract further due to higher mortgage rates. Non-tech industrial firms, which rely on debt financing, will also experience squeezed margins and reduced capital expenditure plans. Additionally, labor market conditions are anticipated to deteriorate, with hiring demand expected to weaken further as borrowing costs rise across consumer auto loans, mortgages, and corporate credit lines.