Our Global Head of Macro Strategy Matt Hornbach and U.S.
Economist Michael Gapen assess the Fed’s path forward in light of
inflation and a weaker economy, and the likely market outcomes.
Read more insights from Morgan Stanley.
----- Transcript -----
Matt 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.
Matt Hornbach: Today we're discussing the
outcome of the June Federal Open Market Committee meeting and our
expectations for rates, inflation, and the U.S. dollar from
here.
It's Thursday, June 26th at 10am in New York.
Matt Hornbach: Mike, the Federal Reserve
decided to hold the federal funds rate steady, remaining within
its target range of 4.25 to 4.5 percent. It still anticipates two
rate cuts by the end of 2025; but participants adjusted their
projections further out suggesting fewer cuts in 2026 and
2027.
You, on the other hand, continue to think the Fed will stay on
hold for the rest of this year, with a lot of cuts to follow in
2026. What specifically is behind your view, and are there any
underappreciated dynamics here?
Michael Gapen: So, we've been highlighting
three reasons why we think the Fed will cut late but cut more.
The first is tariffs introduce differential timing effects on the
economy. They tend to push inflation higher in the near term and
they weaken consumer spending with a lag. If tariffs act as a tax
on consumption, that tax is applied by pushing prices higher –
and then only subsequently do consumers spend less because they
have less real income to spend. So, we think the Fed will be
seeing more inflation first before it sees the weaker labor
market later.
The second part of our story is immigration. Immigration controls
mean it's likely to be much harder to push the unemployment rate
higher. That's because when we go from about 3 million immigrants
per year down to about 300,000 – that means much lower growth in
the labor force. So even if the economy does slow and labor
demand moderates, the unemployment rate is likely to remain low.
So again, that's similar to the tariff story where the Fed's
likely to see more inflation now before it sees a weaker labor
market later.
And third, we don't really expect a big impulse from fiscal
policy. The bill that's passed the house and is sitting in the
Senate, we’ll see where that ultimately ends up. But the details
that we have in hand today about those bills don't lead us to
believe that we'll have a big impulse or a big boost to growth
from fiscal policy next year.
So, in total the Fed will see a lot of inflation in the near term
and a weaker economy as we move into 2026. So, the Fed will be
waiting to ensure that that inflation impulse is indeed
transitory, but a Fed that cuts late will ultimately end up
cutting more.
So we don't have rate hikes this year, Matt, as you noted. But we
do have 175 basis points in rate cuts next year.
Matt Hornbach: So, Mike, looking through
the transcript of the press conference, the word tariffs was used
almost 30 times. What does the Fed's messaging say to you about
its expectations around tariffs?
Michael Gapen: Yeah, so it does look like
in this meeting, participants did take a stand that tariffs were
going to be higher, and they likely proceeded under the
assumption of about a 14 percent effective tariff rate. So, I
think you can see three imprints that tariffs have on their
forecast.
First, they're saying that inflation moves higher, and in the
press conference Powell said explicitly that the Fed thinks
inflation will be moving higher over the summer months. And they
revised their headline and core PCE forecast higher to about 3
percent and 3.1 percent – significant upward revisions from where
they had things earlier in the year in March before tariffs
became clear. The second component here is the Fed thinks any
inflation story will be transitory. Famous last words, of course.
But the Fed forecast that inflation will fall back towards
the 2 percent target in 2026 and 2027; so near-term impulse that
fades over time. And third, the Fed sees tariffs as slowing
economic growth. The Fed revised lower its outlook for growth in
real GDP this year. So, in some [way], by incorporating tariffs
and putting such a significant imprint on the forecast, the Fed's
outlook has actually moved more in the direction of our own
forecast.
Matt Hornbach: I'd like to stay on the
topic of geopolitics. In contrast to the word tariffs, the words
Middle East only was mentioned three times during the press
conference. With the weekend events there, investor concerns are
growing about a spike in oil prices. How do you think the Fed
will think about any supply-driven rise in energy, commodity
prices here?
Michael Gapen: Yeah, I think the Fed will
view this as another element that suggests slower growth and
stickier inflation. I think it will reinforce the Fed's view of
what tariffs and immigration controls do to the outlook. Because
historically when we look at shocks to oil prices in the U.S.; if
you get about a 10 percent rise in oil prices from here, like
another $10 increase in oil prices; history would suggest that
will move headline inflation higher because it gets passed
directly into retail gasoline prices. So maybe a 30 to 40 basis
point increase in a year-on-year rate of inflation. But the
evidence also suggests very limited second round effects, and
almost no change in core inflation.
So, you get a boost to headline inflation, but no persistence
elements – very similar to what the Fed thinks tariffs will do.
And of course, the higher cost of gasoline will eat into consumer
purchasing power. So, on that, I think it's another force that
suggests a slower growth, stickier inflation outlook is likely to
prevail.
Okay Matt, you've had me on the hot seat. Now it's your turn. How
do you think about the market pricing of the Fed's policy path
from here? It certainly seems to conflict with how I'm thinking
about the most likely path.
Matt Hornbach: So, when we look at market
prices, we have to remember that they are representing an average
path across all various paths that different investors might
think are more likely than not. So,
the market price today, has about 100 basis points of cuts by the
end of 2026. That contrasts both with your path in terms of
magnitude. You are forecasting 175 basis points of rate cuts; the
market is only pricing in 100. But also, the market pricing
contrasts with your policy path in that the market does have some
rate cuts in the price for this year, whereas your most likely
path does not.
So that's how I look at the market price. You know, the question
then becomes, where does it go to from here? And that's something
that we ultimately are incorporating into our forecasts for the
level of Treasury yields.
Michael Gapen: Right. So, turning to that,
so moving a little further out the curve into those longer dated
Treasury yields. What do you think about those? Your forecast
suggests lower yields over the next year and a half. When do you
think that process starts to play out?
Matt Hornbach: So, in our projections, we
have Treasury yields moving lower, really beginning in the fourth
quarter of this year. And that is to align with the timing of
when you see the Fed beginning to lower rates, which is in the
first quarter of next year. So, market prices tend to get ahead
of different policy actions, and we expect that to remain the
case this year as well. As we approach the end of the year, we
are expecting Treasury yields to begin falling more precipitously
than they have over recent months.
But what are the risks around that projection? In our view, the
risks are that this process starts earlier rather than later. In
other words, where we have most conviction in our projections is
in the direction of travel for Treasury yields as opposed to the
timing of exactly when they begin to fall. So, we are
recommending that investors begin gearing up for lower Treasury
yields even today. But in our projections, you'll see our numbers
really begin to fall in the fourth quarter of the year, such that
the 10-year Treasury yield ends this year around 4 percent, and
it ends 2026 closer to 3 percent.
Michael Gapen: And these days it's really
impossible to talk about movements in Treasury yields without
thinking about the U.S. dollar. So how are you thinking about the
dollar amidst the conflict in the Middle East and your outlook
for Treasury yields?
Matt Hornbach: So, we are projecting the
U.S. dollar will depreciate another 10 percent over the next 12
to 18 months. That's coming on the back of a pretty dramatic
decline in the value of the dollar in the first six months of
this year, where it also declined by about 10 percent in terms of
its value against other currencies.
So, we are expecting a continued depreciation, and the conflict
in the Middle East and what it may end up doing to the energy
complex is a key risk to our view that the dollar will continue
to depreciate, if we end up seeing a dramatic rise in crude oil
prices. That rise would end up benefiting countries, and the
currencies of those countries who are net exporters of oil; and
may end up hurting the countries and the currencies of the
countries that are net importers of oil. The good news is that
the United States doesn't really import a lot of oil these days,
but neither is it a large net exporter either.
So, the U.S. in some sense turns out to be a bit of a neutral
party in this particular issue. But if we see a rise in energy
prices that could benefit other currencies more than it benefits
the U.S. dollar. And therefore, we could see a temporary reprieve
in the dollar’s depreciation, which would then push our forecast
perhaps a little bit further into the future.
So, with that, Mike, thanks for taking the time to talk.
Michael Gapen: It's great speaking with
you, Matt.
Matt Hornbach: And thanks for listening. If
you enjoy thoughts on the Market, please leave us a review
wherever you listen and share the podcast with a friend or
colleague today.
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