Our Global Head of Macro Strategy Matthew Hornbach and Chief U.S.
Economist Michael Gapen discuss the path for U.S. interest rates
after the nomination of Kevin Warsh for next Fed chair.
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'll be talking
about the Federal Open Market Committee meeting that occurred
last week.
It's Thursday, February 5th at 8:30 am in New York.
So, Mike, last week we had the first Federal Open Market
Committee meeting of 2026. What were your general impressions
from the meeting? And how did it compare to what you had thought
going in?
Michael Gapen: Well, Matt, I think that the
main question for markets was how hawkish a hold or how dovish a
hold would this be. As you know, it was widely expected the Fed
would be on hold. The incoming data had been fairly solid.
Inflation wasn't all that concerning, and most of the employment
data suggested things had stabilized. So, it was clear they were
going to pause.
The question was would they pause or would they be on pause,
right? And in our view, it was more of a dovish hold. And by
that, it suggests to us, or they suggested to us, I should say,
that they still have an easing bias and rates should generally
move lower over time.
So, that really was the key takeaway for me. Would they signal a
prolonged pause and perhaps suggest that they might be done with
the easing cycle? Or would they say, yes, we've stopped for now,
but we still expect to cut rates later? Perhaps when inflation
comes down and therefore kind of retain a dovish bias or an
easing bias in the policy rate path. So, to me, that was the main
takeaway.
Matthew Hornbach: Of course, as we all
know, there are supposed to be some personnel changes on the
committee this year. And Chair Powell was asked several questions
to try to get at the future of this committee and what he himself
was going to do personally. What was your impression of his
response and what were the takeaways from that part of the press
conference?
Michael Gapen: Well, clearly, he's been
reluctant to, say, pre-announce what he may do when his term is
chair ends in May. But his term as a governor extends
into 2028. So, he has options. He could leave normally that's
what happens. But he could also stay and he's never really made
his intentions clear on that part. I think for maybe personal or
professional reasons. But he has his own; he has his own reasons
and, and that's fine.
And I do think the recent subpoena by the DOJ has changed the
calculus in that. At least my own view is that it makes it more
likely that he stays around. It may be easier for him to act in
response to that subpoena by being on staff. It's a request for
additional information; he needs access to that information. I
think you could construct a reasonable scenario under which,
‘Well, I have to see this through, therefore, I may stay around.’
But maybe he hasn't come to that conclusion yet.
And then stepping back, that just complicates the whole picture
in the sense that we now know the administration has put forward
Kevin Warsh as the new Fed chair. Will he be replacing the seat
that Jay Powell currently sits in? Will he be replacing the seat
that Stephen Myron is sitting in?
So yes, we have a new name being put forward, but it's not
exactly clear where that slot will be; and what the composition
of the committee will look like.
Matthew Hornbach: Well, you beat me to the
punch on mentioning Kevin Warsh…
Michael Gapen: I kind of assumed that's
where you were going.
Matthew Hornbach: It was going to be my
next question. I'm curious as to what you think that
means for Fed policy later this year, if anything. And what it
might mean more medium term?
Michael Gapen: Yeah. Well, first of all,
congratulations to Mr. Warsh on the appointment. In terms of what
we think it means for the outlook for the Fed's reaction function
and interest rate policy, we doubt that there will be a material
change in the Fed's reaction function.
His previous public remarks don't suggest his views on interest
rate policy are substantively outside the mainstream, or at least
certainly the collective that's already in the FOMC. Some people
would prefer not to ease. The majority of the committee still
sees a couple more rate cuts ahead of them.
Warsh is generally aligned with that, given his public remarks.
But then also all the reserve bank presidents have been
renominated. There's an ongoing Supreme Court case about the
ability of the administration to fire Lisa Cook. If that is not
successful, then Kevin Warsh will arrive in an FOMC where there's
16 other people who all get a say. So, the chair's primary
responsibility is to build a consensus; to herd the cats, so to
speak. To communicate to markets and communicate to the
public.
So, if Mr. Warsh wanted to deviate substantially from where the
committee was, he would have to build a consensus to do that. So,
we think, at least in the near term, the reaction function won't
change. It'll be driven by the data, whether the labor market
holds up, whether inflation, decelerates as expected. So, we
don't look for material change.
Now you also asked about the medium term. I do think where his
views differ, at least with respect to current Fed policy is on
the size of the Fed's balance sheet and its footprint in
financial markets. So, he has argued over time for a much smaller
balance sheet. He's called the Fed's balance sheet bloated. He
has said that it creates distortions in markets, which mean
interest rates could be higher than they otherwise would be. And
so, I think if there is a substantive change in Fed policy going
forward, it could be there on the balance sheet.
But what I would just say on that is it'll likely take a lot of
coordination with Treasury. It will likely take changes in rules,
regulations, the supervisory landscape. Because if you want to
reduce the balance sheet further without creating volatility in
financial markets, you have to find a way to reduce bank demand
for it. So, this will take time, it'll take study, it'll take
patience. I wouldn't look for big material changes right out of
the box.
So Matt, what I'd like to do is, if I could flip it back to you,
Warsh was certainly one of the expected candidates, right? So,
his name is not a surprise. But as we knew financial markets, one
day we're thinking it'd be one candidate. The next day it'd be
thinking at the next it was somebody else.
How did you see markets reacting to the announcement of Mr.
Warsh? For the next Fed share, and then maybe put that in context
of where markets were coming out of the last FOMC meeting.
Matthew Hornbach: Yeah, so the markets that
moved the most were not the traditional, very large macro markets
like the interest rate marketplace or the foreign exchange
market. The markets that moved the most were the prediction
markets. These newer markets that offer investors the ability to
wager on different outcomes for a whole variety of events around
the world. But when it comes to the implications of a
Kevin Warsh led Fed – for the bigger macro markets like interest
rates and currencies, the question really comes down to
how?
If the Fed's balance sheet policies are going to take a while to
implement, those are not going to have an immediate effect, at
least not an effect that is easily seen with the human eye. But
it's other types of policy change in terms of his communication
policy, for example. One of the points that you raised in your
recent note, Mike, was how Kevin Warsh favored less communication
than perhaps some of the recent, Federal Open Market Committees
had with the public.
And so, if there is some kind of a retrenchment from the type of
over-communication to the marketplace, from either committee
members or non-voters that could create a bit more volatility in
the marketplace. Of course, the Fed has been one of the central
banks that does not like to surprise the markets in terms of its
monetary policy making. And so, that contrasts with other central
banks in the G10. For example, the Swiss National Bank tends to
surprise quite a lot. The Reserve Bank of Australia tends to
surprise markets. More often, certainly than the Fed does. So, to
the extent that there's some change in communication strategy
going forward that could lead to more volatile interest rate in
currency markets.
And that then could cause investors to demand more risk premium
to invest in those markets. If you previously were comfortable
owning a longer duration Treasury security because you felt very
comfortable with the future path of Fed policy, then a Kevin
Warsh led Fed – if it decides to change the communication
strategy – could naturally lead investors to demand more risk
premium in their investments. And that, of course, would lead to
a steeper U.S. Treasury curve, all else equal. So that would be
one of the main effects that I could see happen in markets as a
result of some potential changes that the Fed may consider going
forward.
So, Mike, with that said, this was the first FOMC meeting of the
year, and the next meeting arrives in March. I guess we'll just
have to wait between now and then to see if the Fed is on hold
for a longer period of time or whether or not the data convinced
them to move as soon as the March meeting.
Thanks for taking time to talk, Mike.
Michael Gapen: Great speaking with you,
Matt.
Matthew Hornbach: And thanks for listening.
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