Our Global Chief Economist Seth Carpenter joins our chief
regional economists to discuss the outlook for interest rates in
the U.S., Japan and Europe.
Read more insights from Morgan Stanley.
----- Transcript -----
Seth Carpenter: Welcome to Thoughts on the
Market. I'm Seth Carpenter, Morgan Stanley's Global Chief
Economist and Head of Macro Research. And today we're kicking off
our quarterly economic roundtable for the year. We're going to
try to think about everything that matters in economics around
the world. And today we're going to focus a little bit more on
central banking. And when we get to tomorrow, we'll
focus on the nuts and bolts of the real side of the
economy.
I'm joined by our chief regional economists.
Michael Gapen: Hi, Seth. I'm Mike Gapen,
Chief U.S. Economist at Morgan Stanley.
Chetan Ahya: I'm Chetan Ahya, Chief Asia
economist.
Jens Eisenschmidt: And I'm Jens
Eisenschmidt, Chief Europe economist.
Seth Carpenter: It's Thursday, January 22nd
at 10 am in New York.
Jens Eisenschmidt: And 4 pm in
Frankfurt.
Chetan Ahya: And 9 pm in Hong Kong.
Seth Carpenter: So, Mike Gapen, let
me start with you as we head into 2026, what are we thinking
about? Are we going into a more stable expansion? Is this just a
different phase with the same amount of volatility? What do you
think is going to be happening in the U.S. as a baseline outlook?
And then if we're going to be wrong, which direction would we be
wrong?
Michael Gapen: Yeah, Seth, we took the view
that we would have more policy certainty. Recent weeks have maybe
suggested we're incorrect on that front. But I still believe that
when it comes to deregulation, immigration policy and fiscal
policy, we have much more clarity there than we did a year
ago.
So, I think it's another year of modest growth, above trend
growth. We're forecasting something around 2.4 percent for 2026.
That's about where we finished 2025.
I think what's key for markets and the outlook overall will be
whether inflation comes down. Firms are still passing through
tariffs to the consumer. We think that'll happen at least through
the end of the first quarter. It's our view that after that,
inflation pressures will start to diminish. If that's the case,
then we think the Fed can execute one or two more rate
cuts. But we have those coming [in] the second half of
the year. So, it looks like growth is strong enough. The labor
market has stabilized enough for the Fed to wait and see, to look
around, see the effects of their prior rate cuts, and then push
policy closer to neutral if inflation comes down.
Seth Carpenter: And if we go back to last
year to 2025, I will give you the credit first. Morgan Stanley
did not shift its forecast for recession in the U.S. the way some
of our main competitors did.
On the other hand, and this is where I maybe tweak you just a
little bit. We underestimated how much growth there would be in
the United States. CapEx spending from AI firms was strong.
Consumer spending, especially from the top half of the income
distribution in the U.S. was strong. Growth overall for the year
was over 2 percent, close to 2.5 percent. So, if that's what
we just came off of, why isn't it the case that we'd see even
stronger growth? Maybe even a re-acceleration of growth in
2026?
Michael Gapen: Well, some of that, say,
improvement vis-à-vis our forecast, the outperformance. Some of
that I think comes mechanically from trade and inventory
variability. So, . I'm not sure that that says a lot about an
improving trend rate of growth.
Where there was other outperformance was, as you noted, from the
consumer. Now our models, and I don't mean to get too technical
here, but our model suggests that consumption is overshooting its
fundamentals. Which I think makes it harder for the
economy to accelerate further. And then AI; it's harder for AI
spending to say get incrementally stronger than where it is. So,
we’re getting a little extra boost from fiscal. We've got that
coming through. And I just think what it is, is more of the same
rather than further acceleration from here.
Seth Carpenter: Do you
think there's a chance that the Fed in fact does not cut rates
like you have in your forecast?
Michael Gapen: Yes, I do think... Where we
could be wrong is we've made assumptions around the
One Big Beautiful Bill and what it will contribute to the
economy. But as you know, there's a lot of variability around
those estimates.
If the bill is more catalytic to animal spirits and business
spending than we've assumed, you could get, say, a demand driven
animal spirits upside to the economy, which may mean inflation
doesn't decelerate all that much. But I do think that
that's, say, the main upside risk that we're considering. Markets
have been gradually taking out probabilities of Fed cuts as
growth has come in stronger. So far, the inflation data has been
positive in terms of signaling about disinflation, but I would
say the jury's still out on how much that continues.
Seth
Carpenter: Chetan, When
I think about Japan, we know that it's been the developed market
central bank that's been going in the opposite direction. They've
been hiking when other central banks have been cutting. We got
some news recently that probably put some risk into our baseline
outlook that we published in our year ahead view about both
growth and inflation in Japan. And with it what the Bank of Japan
is going to do in terms of its normalization.
Can you just walk us through a little bit about our outlook for
Japan? Because right now I think that the yen, Japanese rates,
they're all part of the ongoing market narrative around the
world.
Chetan Ahya: Yeah, Seth. So, look, I mean,
on a big picture basis, we are constructive on the Japan
macro-outlook. We think normal GDP growth remains strong. We are
expecting to see the transition for the consumers from them
seeing, you know, supply side inflation. Keeping their real wage
growth low to a dynamic where we transition to real wage growth
accelerating. That supports real consumption growth, and we move
away from that supply side driven inflation to demand side driven
inflation.
So broadly we are constructive, but I think in the backdrop, what
we are seeing on currency depreciation is making things a bit
more challenging for the BOJ.
While we are expecting that demand side pressure to build up and
drive inflation, in the trailing data, it is still pretty much
currency depreciation and supply side factors like food inflation
driving inflation. And so, BOJ has been hesitant. So,
while we had the expectation that BOJ will hike in January of
2027, we do see the risk that they may have to take up rate hike
earlier to manage the currency not getting out of hand and adding
on to the inflation pressures.
Seth Carpenter Would I be right in saying
that up until now, the yen has swung pretty widely in both
directions. But the weakening of the yen until now hasn't been
really the key driver of the Bank of Japan's policy reaction.
It's been growth picking up, inflation picking up, wanting to get
out of negative interest rates first, wanting to get away from
the zero lower bounds.
Second, the weaker yen in some sense could have actually been
seen as a positive up until now because Japan did go through 25
years of essentially stagnant nominal growth. Is this actually
that much of a fundamental change in the Bank of Japan's thinking
– needing to react to the weakness of the yen?
Chetan Ahya: Broadly what you're saying is
right, Seth, but there is also a threshold of where the currency
can be. And beyond a point, it begins to hurt the households in
form of imported inflation pressures. And remember that inflation
has been somewhat high, even if it is driven by currency
depreciation and supply side factors for some time. And so, BOJ
has to be watchful of potential lift in inflation expectations
for the households. And at the same time, they are also watching
the underlying inflation impact of this currency depreciation –
because what we have seen is that over period workers have been
demanding for higher wages. And that is also influenced by what
happens to headline inflation, which is driven by currency
depreciation. So, I would say that, yes, it's been true up until
now. But, when currency reaches these very high levels of range,
you are going to see BOJ having to act.
Seth Carpenter: Jens, let's shift
then to Europe. The ECB had been on a cutting cycle. They
came to the end of that. President Lagarde said that she thought
the disinflationary process had ended.
In your year ahead forecast and a bunch of your writing recently,
you've said maybe not so fast. There could still be some more
disinflationary, at least risk, in the pipeline for Europe. Can
you talk a little bit about what's going on in terms of European
inflation and what it could mean for the European Central Bank?
Because clearly that's going to be first order important for
markets.
Jens Eisenschmidt: I think that is right. I
think we have a crucial inflation print ahead of us that comes
out on the 4th of February. So, early February we get some
signal, whether our anticipated fall of headline inflation here
below the ECB’s target is actually materializing. We think the
chances for this are pretty good.
There's a mix why this is happening. One is energy. Energy
disinflation and base effects. But the other thing is services
inflation resets always at the beginning of the year. January and
February are the crucial month here. We had significant services
upward pressure on prices the last years. And so just from base
effects, we think we will see less of that. Another picture or
another element of that picture is that wage disinflation is
proceeding nicely. We have notably a significant weakness in the
export-oriented manufacturing sector in Germany, which is a key
sector of setting wages for the country. The country is around 30
percent of the euro area GDP. And here we had seen significant
wage gains over the last year. So, the disinflationary trend
coming from lower wage gains from this country, that will be very
important. And an important signal to watch.
Again, that's something we don't know. I think soon we have to
watch simply monthly prints here. But a significant print for the
first quarter comes out in May, and all of that together makes us
believe that the ECB will be in a position to see enough data or
have seen enough data that confirms the thesis of inflation
staying below target for some time to come. So that they can cut
in June and September to a terminal rate of 1.5 percent.
Seth Carpenter: That is, I
would say, out of consensus relative where the market is. When
you talk to investors, whether they're in Europe or around the
world, what's the big pushback that you get from them when you
are explaining your view on how the ECB is going to act?
Jens Eisenschmidt: There are
two essential pushbacks. So, one is on substance. So, 'No,
actually wages will not come down, and the economy will actually
start overheating soon because of the big fiscal stimulus.' That,
in a nutshell is the pushback on substance. I would say here, as
you would say before, not so fast. Because the fiscal stimulus is
only in one country. It's 30 percent. But only 30 percent of the
euro area.
Plus, there is another pushback, which is on the reaction
function of the ECB. Here we tend to agree. So far, we have heard
from policy makers that they feel rather comfortable with the 2
percent rate level that they're at. But we think that discussion
will change. The moment you are below target in an actual
inflation print; the burden of proof is the opposite. Now you
have to prove: Is the economy really on a track that inflation
will get back up to target without further monetary
stimulus?
We believe that will be the key debate. And again, happy to, sort
of, concede that there is for now not a lot of signaling out of
the ECB that further rate cuts are coming. But we believe the
first inflation print of the year will change that debate
significantly.
Seth Carpenter: Alright, so that makes a
lot of sense. However, looking at the clock, we are probably
out of time for today. So, for now, Michael, Chetan, Jens, thank
you so much for joining today. And to the listener, thanks for
listening. And be sure to tune in tomorrow for part two of our
conversation.
And I have to say, if you enjoy this show, please leave us a
review wherever you listen and share Thoughts on the Market with
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