Our Global Head of Macro Strategy joins our Chief U.S. Economist
to discuss the Fed’s recent rate cut and why persistent inflation
is likely to slow the pace of future cuts.
----- Transcript -----
Matthew Hornbach: Welcome to Thoughts on
the Market. I'm Matthew Hornbach, Global Head of Macro Strategy.
Michael Gapen: And I'm Michael Gapen,
Morgan Stanley's Chief U.S. Economist.
Matthew: Today, we're going to talk about
the Federal Open Market Committee meeting and the path for rates
from here.
It's Thursday, December 19th at 10a.m. in New York.
The FOMC meeting concluded yesterday with the Federal Reserve
cutting rates by a quarter of a percentage point, marking the
third rate cut for the year. This move by the Fed was just as the
consensus had anticipated. However, in its meeting yesterday, the
Fed indicated that 2025 rate cuts would happen at a slower pace
than investors were expecting. So Mike, what are committee
members projecting in terms of upcoming rate cuts in 2025 and
2026?
Michael: Yeah, Matt, the Fed dialed back
its expectations for policy rate easing in both 2025 and 2026.
They now only look for two rate cuts of 50 basis points
worth of cuts in 2025, which would bring the funds rate to
3.9% and then only another 50 basis points in 2026, bringing
the policy rate to 3.4%. So a major dialing back in their
expectations of rate cuts over the next two years.
Matthew: What are the factors that are
driving what now appears to be a slightly less dovish view of the
policy rate?
Michael: Chair Powell mentioned, I think,
two things that were really important. One, he said that many
committee members saw recent firmness in inflation as a surprise.
And so I think some FOMC members extrapolated that strength in
inflation going forward and therefore thought fewer rate cuts
were appropriate. But Chair Powell also said other FOMC
members incorporated expectations about potential changes in
policy, which we inferred to mean changes about tariffs,
immigration policy, maybe additional fiscal spending. And so
whether they bake that in as explicit assumptions or just saw it
as risks to the outlook, I think that these were the two main
factors. So either just momentum in inflation or views on
policy rate changes, which could lead to greater inflation going
forward.
Matthew: So Mike, what were your
expectations going into this meeting and how did yesterday's
outcome change Morgan Stanley's outlook for Federal Reserve
policy next year and the year thereafter?
Michael: We are a little more
comfortable with inflation than the Fed appears to be. So we
previously thought the Fed would be cutting rates three times
next year and doing all of that in the first half of the year.
But we have to listen to what they're thinking and it appears
that the bar for rate cuts is higher. In other words, they
may need more evidence to reduce policy rates. One month of
inflation isn't going to do it, for example. So what we did is we
took one rate cut out of the forecast for 2025. We now only look
for two rate cuts in 2025, one in March and one in June.
As we look into 2026, we do think the effect of higher tariffs
and restrictions on immigration policy will slow the economy
more, so we continue to look for more rate cuts in 2026 than the
Fed is projecting but obviously 2026 is a long way away. So
in short, Matt, we dialed back our assumptions for policy rate
easing to take into account what the Fed appears to be saying
about a higher bar for comfort on inflation before they ease
again.
So Matt, if I can actually turn it back to you: how, if at
all, did yesterday's meeting, and what Chair Powell
said, change some of your key forecasts?
Matthew: So we came into this meeting
advocating for a neutral stance in the bond market. We had
seen a market pricing that ended up being more in line with the
outcome of the meetings. We didn't expect yields to fall
dramatically in the wake of this meeting, and we didn't expect
yields to rise dramatically in the wake of this meeting. But what
we ended up seeing in the marketplace was higher yields as a
result of a policy projection that I think surprised investors
somewhat and now the market is pricing an outlook that is
somewhat similar to how the Fed is forecasting or projecting
their policy rate into the future.
In terms of our treasury yield forecasts, we didn’t see
anything in that meeting that changes the outlook for treasury
markets all that much. As you said, Mike, that in 2026,
we're expecting much lower policy rates. And that ultimately
is going to weigh on treasury yields as we make our way through
the course of 2025. When we forecast market rates or prices, we
have to think about where we are going to be in the future and
how we're going to be thinking about the future from then. And so
when we think about where our treasury yield's going to be
at the end of 2025, we need to try to invoke the views of
investors at the end of 2025, which of course are going to be
looking out into 2026.
So when we consider the rate policy path that you're projecting
at the moment and the factors that are driving that rate policy
projection - a slower growth, for example, a bit more
moderate inflation - we do think that investors will be
looking towards investing in the government bond market as we
make our way through next year, because 2026 should be even more
supportive of government bond markets than perhaps the economy
and Fed policy might be in 2025.
So that's how we think about the interest rate marketplace. We
continue to project a 10 year treasury yield of just about three
and a half percent at the end of 2025 that does seem a ways away
from where we are today, with the 10 year treasury yield closer
to four and a half percent, but a year is a long time. And
that's plenty of time, we think, for yields to move
lower gradually as policy does as well. On the foreign
exchange side. The dollar we are projecting to soften next year,
and this would be in line with our view for lower treasury
yields. For the time being, the dollar reacted in a
very positive way to the FOMC meeting this week but we think in
2025, you will see some softening in the dollar. And that
primarily occurs against the Australian dollar,
the Euro, as well as the Yen. We are projecting the
dollar/yen exchange rate to end next year just below 140, which
is going to be quite a move from current levels, but we do think
that a year is plenty of time to see the dollar
depreciate and that again links up very nicely with our
forecast for lower treasury yields.
Mike, with that said, one more question for you, if you
would: where do things stand with inflation now? And how
does this latest FOMC signal, how does it relate to inflation
expectations for the year ahead?
Michael: So right now, inflation has been a
little bit stronger than we and I think the Fed had anticipated,
and that's coming from two sources. One, hurricane-related
effects on car prices. So the need to replace a lot of cars has
pushed new and used car prices higher. We think that's a
temporary story that's likely to reverse in the coming months.
The more longer term concern has been around housing related
inflation, or what we would call shelter inflation. The good
news in that is in November, it took a marked step lower. So
I do think it tells us that that component, which has been
holding up inflation, will continue to move down. But as we look
ahead to your point about inflation
expectations, the real concern here is about potential
shifts in policy, maybe the implementation of tariffs, the
restriction of immigration.
We as economists would normally say those should have level
effects or one-off effects on inflation. And normally I'd have a
high confidence in that statement. But we just came out of a very
prolonged period of higher than normal inflation, so I think the
concern is repetitive, one-off shocks to inflation, lead
inflation expectations to move higher. Now, we don't think
that will happen. Our outlook is for rate cuts, but
this is the concern. So we think inflation moves lower.
But we're certainly watching the behavior of inflation
expectations to see if our forecast is misguided.
Matthew: Well, great Mike. Thanks so much
for taking the time to talk.
Mike: Great speaking with you, Matt.
Matthew: And thanks for
listening. If you enjoy Thoughts on the Market, please leave
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