Our Global Head of Macro Strategy Matthew Hornbach and Chief U.S.
Economist Michael Gapen discuss the Fed’s path as inflation
remains above its target and the labor market continues cooling.
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: Yesterday, the FOMC
meeting delivered another quarter percentage point rate cut.
Today we're here to discuss what happens next.
It's Thursday, December 11th at 8:30 AM in New York.
So, Mike, once again, the Fed cut rates by 25 basis points. That
outcome was not a surprise, and the markets reacted positively.
But there were some surprises. A bit of a divided FOMC, if you
will. How did things play out during the meeting and what are
some important takeaways to keep in mind?
Michael Gapen: Yeah, well certainly Matt,
it is a divided committee. I think that's clear.
I think one key takeaway for me is the idea that the Fed is done
with risk management rate cuts, and now we're back to data
dependent. So, what does that mean? I mean, a risk management
rate cut isn't necessarily about the data you have in hand and
the data you see; it's your view about the distribution of risks
around that.
So, in some ways, you're not data dependent when you're making
those cuts. Now, I think the challenge at this press conference
for Powell was to say, ‘Well, now things are different.’ And it
was a nuance in the sense that cuts from here, if and when they
come, will be data dependent.
But I think at the same time he did not want to communicate that
the bar for those rate cuts were exceptionally high.
But I think he threaded the needle quite well in transitioning
from risk management cuts, which aren't data dependent to an
outlook, which is now more data dependent. And I thought he did
that artfully well. So, for me, that's the big key.
Secondarily I'd add a takeaway for me was he seems fairly
confident that inflation will be coming down, and I think he
still believes the labor market is cooling. The blend of that
came across as a bit dovish to me. And then the third thing I
would add is he fairly explicitly ruled out the risk of rate
hikes. So, I think the combination of those three things: data
dependence, still concerns about cooling in the labor market, and
chopping off the upper half of the rate path distribution – those
were kind of the key takeaways from my point.
Matthew Hornbach: So, Mike, with respect to
the labor market, Chair Powell did address it in a couple of
different ways. But one of the ways that stood out to my ears was
how he described some technical factors that people are well
aware of – that could mean the economy is actually shedding jobs
to the tune of about 20,000 per month.
I was wondering if you could just briefly address what those
factors – that are supposedly so well known – might be.
Michael Gapen: Sure. So, obviously the data
that gets released, there are the initial releases and then there
are revisions. And in the labor market, there are what are called
annual benchmark revisions.
So, the BLS released a preliminary estimate of that benchmark
revision several months ago, and if you apply that initial
estimate, it would suggest that job growth in 2025 could be about
60,000 jobs per month, less than has already been reported.
But at the same time, we know immigration controls are slowing
growth in the labor force. So, this is what Powell is calling the
really curious balance. How can you have employment growth
basically zero, maybe even negative, after these revisions come
in – and the unemployment rate relatively stable. Yes, it's gone
up a few tenths, but not like you would normally expect that rise
would be if we were shedding jobs. So that to me is why he… You
know; the technical factors about revisions and things that lead
them to be, I think, very unsure about where the labor market is;
and lean in the direction of thinking lower rates are better to
manage those risks than where they were six months ago.
Matthew Hornbach: One of the points that
you raised in your opening explanation of the meeting was about
inflation. And Chair Powell mentioned an expectation that the
inflation related to tariffs would be peaking in the first
quarter of the year. That sounded very familiar to me because I
believe that's your expectation as well.
I'm curious. How are you looking at tariffs and the inflation
related to tariffs today? And do you agree with Chair Powell
still?
Michael Gapen: We do. Our modeling of the
tariff pass through and our conversations with clients and firms
and what we hear on corporate earnings calls suggests that this
is a long process. Meaning tariffs go in place, prices don't go
up the next month. Firms make pricing decisions that take time to
implement. So, we agree that the tariff pass through story will
extend into 2026 and likely through the end of the first quarter.
And if that's true, then goods prices should continue to move
higher. The year-on-year rate of inflation should move higher,
peaking at 3 percent or a little above in the first quarter of
the year.
And then tat effect should we think be over, which would open the
door for overall inflation to start coming back down.
So, I will use the dreaded T-word. We think ultimately inflation
from tariffs will be transitory. And I agree with the Chair's
timeline; inflation should peak in the first quarter of the year
and then start to trend down. That said, we think inflation will
be above the Fed's 2 percent target into 2027, and this is the
cost of providing insurance to the labor market.
Matthew Hornbach: So finally, all things
considered, what is your outlook for Fed policy in 2026?
Michael Gapen: Yeah, and the key here,
Matt, is that exactly what you just implied about tariffs and
inflation still going on into 2026, right? Because what we know
is while firms are gauging exactly where they should be pricing,
they've been offsetting tariffs through lower demand for
labor.
So, we think the Fed will be cutting again in January. We have
three months of employment data that come across two employment
reports between now and the January meeting. We think they will
show continued cooling in the labor market. And then we have a
second cut next year in in April. So, while tariffs are getting
passed through, we think the labor market will continue to
cool.
And this Fed will be biased to cutting rates to provide support
to the labor market in the process. That would mean the federal
funds rate gets to 3 – 3.25 percent in the second quarter of
2026, where we think it'll stay.
So Matt, I'd like to ask you a question. What I noticed was the
rate market backed up going into the meeting, despite the fact
that market participants were projecting a cut. And then the rate
market rallied, in my view, significantly during the meeting and
right after. What do you think was happening there?
Matthew Hornbach: So, there's a phenomenon
that happens in all markets where investors often speculate on a
potential outcome. And if the outcome is then delivered, the
follow-on price action is underwhelming. That is colloquially
known as buying the rumor and selling the fact. So, I think going
into this meeting kind of in line with your expectations,
investors were forming very similar expectations about how the
FOMC statement itself would change and the implications that that
might have for the future of Fed policy.
When that hawkish cut was delivered almost exactly as you had
expected, Mike, I think, investors started thinking about the
future in a slightly different way. Now that their expectations
were met with the meeting outcome, they started to consider, the
data that is forthcoming. And whenever, officials at the Fed talk
about data in the way that Chair Powell spoke about the data –
and by which I mean labeled the labor market as potentially
losing jobs at the moment, and labeling inflation as transitory,
that we'd be past the peak of tariff related inflation after the
first quarter of the year.
Investors can kind of look at those factors and extrapolate going
forward, what that may mean for Fed policy in the first half of
2026. So, I think similar to your expectations for policy after
this meeting, investors probably became a bit more confident in
your outlook for Fed policy that we would see additional rate
cuts in the first half of next year.
And then, of course, after the April meeting, the baton will be
passed to the next Fed chair, and I think investors are
considering what policy might look like under that new regime at
the Fed. And on the margin, the view is that the next Fed chair
would be more likely than not to continue the process of lowering
policy rates. So, I think all of those factors played into the
post press conference, and even during the press conference
reaction.
Michael Gapen: Okay Matt, one last
question, if I may. How did the events of the FOMC this week and
the market reaction, how does that dovetail with how you're
thinking about longer term rates, in particular where you see
10-year yields going? And the dollar?
Matthew Hornbach: So, 10-year yields are
relatively close to 4 percent at this juncture, and we expect
them to drift modestly lower in the first half of 2026, as the
Fed continues this process of lowering the policy rate.
One point that's very important to make here is that the
longer-term Treasury yields today are now sitting well above the
Fed's policy rate, and that hasn't been the case for many, many
years now. A lot of investors with whom we speak think that
longer term yields can head a lot higher from here. But we're
skeptical – because the higher that those yields go relative to
the Fed's policy rate, the more attractive those bonds become for
other investors to buy. So, we don't expect a big increase in
longer term interest rates. Unlike some investors, we are
expecting interest rates in the long end to remain relatively
stable with a downward bias.
On the dollar, similarly, we have the dollar continuing its
depreciation trend, which it began in January of 2025, earlier
this year. We expect that depreciation trend to continue in the
first half of 2026 before – similar to the interest rate path –
we see a little bit of dollar strength in the second half of the
year.
And so, you know this being the last FOMC meeting of the year,
Mike, I guess we're going to have to take a wait and see approach
until the FOMC reconvenes in the new year. Thanks a lot for
taking the time to talk about the Fed with me this year.
Michael Gapen: Great speaking with you
Matt. See you in 2026.
Matthew Hornbach: And thanks for listening.
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