Our Global Head of Macro Strategy Matthew Hornbach and Chief U.S.
Economist Michael Gapen discuss the outcome of the recent FOMC
meeting, and the outlook for interest rates in 2025 and
2026.
Read more insights from Morgan Stanley.
----- 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 Hornbach: Today we're talking about
the March Federal Open Market Committee meeting and the path for
rates from here.
It's Thursday, March 20th at 10am in New York.
Mike, the Fed released a new set of projections yesterday. What
do these say and what did you learn from them?
Michael Gapen: Yeah, Matt, well, the Fed's
forecast actually now look a lot like our outlook for the U.S.
economy. So, they revised down their expectation of growth. They
revised up their expectation for inflation. So, it has a bit of a
stagflation, slower growth, stickier inflation outlook – which is
very much what we were thinking coming into this year. The Fed
also, though, highlighted high policy uncertainty. They wrote
down a forecast, but I'm not all that convinced that they have a
lot of confidence in how things will evolve.
So, I think for me, really, the bigger story were their updated
perceptions about uncertainty and risks to the outlook. So, in
December, if you remember, they told us; virtually everybody on
the committee said, uncertainty around inflation is high and risk
to inflation to the upside. They complemented that this week with
the fact that uncertainty around growth in the labor market is
high, but risk to growth is to the downside, the unemployment
rate to the upside. So, you have kind of competing risks here
around the Fed's dual mandate. They've got upside risk to
inflation, downside risk to growth.
To me, that's kind of the really important message. It's hard to
have a confidence in a forecast right now, but I think that risk
assessment is really interesting.
Matthew Hornbach: And with that in mind,
and given all the policy uncertainty that the Fed mentioned, what
did Powell say about how the Fed should react? In other words,
what is appropriate policy at this stage?
Michael Gapen: Right. Yeah, it's tricky,
right? So, on one side of your mandate, you think risks to
inflation are squarely to the upside and growth in labor markets
to the downside. So, what do you do? And I think Powell said, I
think that the logical answer, which is, well, right now you do
nothing, and you wait.
But then I think what Powell said is: How we think this plays out
is – tariffs may boost inflation in the short run. Which we're
going to try to ignore. And if the economy does weaken and the
labor market softens, we'll ease policy in order to support
activity, right? So, there might be, say, symmetric risks around
their dual mandate, but there's asymmetry in the policy outlook.
He said we're either going to be on hold or we're going to be
cutting rates. And generally, I think that's the right thing.
Matthew Hornbach: So, Mike, what I heard
from you was that the Fed was going to look through inflation in
the near term, and then eventually cut. I mean, do you think they
can do that?
Michael Gapen: Yeah, I think, Matt, that's
a great question. My answer to that is, I think it's easier said
than done. We agree that the next move from the Fed is going to
be a cut, but we think that cut comes much later.
This is a very data dependent Fed. So, I think in the moment, if
tariffs boost inflation now and weaken activity later, it's easy
to say, ‘I'm going to look through that and cut.’ But in
practice, I think it's hard.
So, Matt, actually, at this point, though, I think I would
actually kind of ask you the same question, but in a different
way, right? We doubt the Fed may be able to do this. But the
market priced in more rate cuts this year than we think is
likely. How would you explain the market pricing and how far away
from my expectation do you think it could run?
Matthew Hornbach: What’s really interesting
about how the market has priced the recent events is – it’s
actually pricing more in line with the spirt of your view. In the
sense that the market has priced more rate cuts in 2026 than it’s
pricing in 2025. So, in spirit, the market is very much with you.
But as we like to say, the market price is an average of all
possible outcomes. And if one of the outcomes is the Fed does
nothing for the foreseeable future. And the other outcome is the
Fed cuts aggressively this year. Then the market price has to
reflect some degree of additional easing in 2025 that wouldn't
necessarily be aligned with a rational baseline for Fed policy.
So, market in some ways is reflecting the idea that you're
proposing in your forecast. But it's also reflecting the idea
that it's a market and that it has to be priced for some amount
of risk premia that the Fed is ultimately forced to cut rates
more.
And in fact, if I can ask you a question relating to that, Mike,
you know, the equity market at one point last week had fallen
about 10 per cent from the highs.
Michael Gapen: Mm hmm.
Matthew Hornbach: Number one, is there a
percentage drawdown that gets the Fed’s attention? You know, how
does the Fed think about the equity market in an environment like
this?
Michael Gapen: Yeah, I think the equity
market, in my view, and I think the view of the Fed, is what I'll
call a key spillover channel. Trade and manufacturing are
relatively small shares of the economy. So, if we pursue
restrictive trade policies, growth should slow, inflation may be
firm. That's the Fed's essential baseline; it's ours. The risk
here though is that somewhere in there you get a destabilizing
period, equity markets fall, upper income consumers take a step
back, and you have a much broader downturn at that point.
So, you ask a great question, how far do equity markets have to
fall? Well, we get 10 per cent declines in equity markets on
average about once a year, so it's not that. And the theory would
say households have to view that decline in wealth as permanent,
right? So, it has to be a fairly substantial decline.
Given how far wealth has risen, we're over [$]51 trillion now and
an increase in net wealth since COVID. I think that decline has
to be large. I would pencil in something, probably need about a
30 per cent decline in equity markets – before maybe that
spillover risk gets very elevated.
So, Matt, if I can turn back, because, you know, I think we're in
general agreement here on what we heard yesterday. But what I'd
like to do in terms of looking forward, so aside from the usual
communications coming from the Fed, after the blackout period,
following the meeting. What do you think investors will be
focusing on over the next month?
Matthew Hornbach: My sense is that there is
already an unusual amount of focus on April 2nd.
You know, that is the day when the Trump administration is
supposed to unveil their plan for reciprocal tariffs. It's
unclear what tariffs will be implemented on April 2nd; what
tariffs will be saved for a negotiating process thereafter. So,
clients are very focused on April 2nd. I also suspect that at
some various periods between now and then, we are likely to
receive previews, in the form of various communications coming
from the Trump administration on the types of policies that we
may end up seeing delivered on April 2nd.
And so, I suspect that between now and then there will be a
crescendo in concern, perhaps, over what will come of U.S. trade
policy for the balance of this year. And really for the balance
of the next three and a half years.
So, with that, Michael, thanks for taking the time to talk.
Michael Gapen: Great speaking with you,
Matt.
Matthew Hornbach: And thanks for listening.
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