Our Chief U.S. Economist Michael Gapen and Global Head of Macro
Strategy Matthew Hornbach discuss potential next steps for the
FOMC and the risks to their views from the U.S. government
shutdown.
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: The October FOMC meeting
delivered a quarter percent rate cut as widely expected – but
things are more complicated, and policy is not on a preset path
from here.
It's Friday, November 7th at 10am in New York.
So, Mike, the Fed did cut by 25 basis points in October, but it
was not a unanimous decision. And the Federal Open Market
Committee decided to end the reduction of its balance sheet on
December 1st – earlier than we expected. How did things unfold
and does this change your outlook in any way?
Michael Gapen: Yeah, Matt, it was a surprise to
me. Not so much the statement or the decision, but there were
dissents. There was a dissent in favor of a 50-basis point cut.
There was a dissent in favor of no cut. And that foreshadowed the
press conference – where really the conversation was about, I
think, a divided committee; and a committee that didn't have a
lot of consensus on what would come next.
The balance sheet discussion, which we can get into, it came a
little sooner than we thought, but it was largely in line with
our view. And I'm not sure it's a macro critical decision right
now. But I do think it was a surprise to markets and it was
certainly a surprise to me – how much Powell's tone shifted
between September and October, in terms of what the market could
expect from the Fed going forward.
So, what he said in essence, the key points, you know. The
policy's not on a preset path from here. Or [a] cut in December
is maybe not decidedly part of the baseline; or certainly is not
a foregone conclusion. And I think what that reflects is a couple
of things.
One is that they're recalibrating policy based on a risk
management view. So, you can cut almost independent of the data,
at least in the beginning. And so now I think Powell's saying,
‘Well, at least from here, future cuts are probably more data
dependent than those initial cuts.’ But second, and I think most
importantly is the division that appeared within the Fed. I think
there's one group that's hawkish, one group that's dovish, and I
think it reflects the division and the tension that we have in
the economic data.
So, I think the hawkish crowd is looking at strong activity data,
strong AI spending, an upper income consumer that seems to be
doing just fine. And they're saying, ‘Why are we cutting?
Financial conditions for the business community is pretty easy.
Maybe the neutral rate of interest is higher. We're probably less
restrictive than you think.’ And then I think the other side of
the committee, which I believe still that Chair Powell is in, is
looking at a market slowdown in hiring a weak labor market. What
that means for growth in real income for those households that
depend on labor market income to consume; there's probably some
front running of autos that artificially boosted growth in the
third quarter.
So, I think that the dissents, or I should say the division
within the FOMC, I think reflects the tension in the underlying
data. So, to know which way monetary policy evolves, Matt, it's
essentially trying to decide: does the labor market rebound
towards the activity data or does the activity data decelerate at
least temporarily to the labor market?
Matthew Hornbach: Mike, you talked a lot about
data just now, and we're not exactly getting a lot of government
data at the moment. How are you thinking about the path for the
data in terms of its availability between now and the December
FOMC meeting? And how do you think that may affect the Fed's
willingness to move forward with another rate cut in the cycle?
Michael Gapen: Right. So that's key and critical
to understanding, right? We're operating under the assumption, of
course the federal government shutdowns going to end at some
point. We're going to get all this back data released and we can
assess where the economy is or has been. I think the way markets
should think about this is if the government shutdown has ended
in the next few weeks, say before Thanksgiving – then I think we,
markets, the Fed will have the bulk of the data in front of them
and available to assess the economy at the December FOMC meeting.
They may not have it all, but they should get at least some of
that data released. We can assess it. If the economy has
moderated and weakened a bit, the labor market has continued to
cool, the Fed can cut. If it shows maybe the labor market
rebounding downside risk to employment being diminished, maybe
the Fed doesn't cut.
So that's a world and it is our expectation the shutdown should
end in the next few weeks. We're already at the longest shutdown
on record, so we will get some data in hand to make the decision
for December. Perhaps that's wishful thinking, Matt, and maybe we
go beyond Thanksgiving, and the shutdown extends into December.
My suspicion though, is if the government is still shut down in
December, I can't imagine the economy's getting better. So, I
think the Fed could lean in the direction of taking one more
step.
Matthew Hornbach: This is going to be very
critical for how the markets think about the outlook in 2026 and
price the outlook for 2026. The last FOMC meeting of the year has
that type of importance for markets – pricing, the path of Fed
policy, and the path of the economy into 2026. Because if we end
up receiving a rate cut from the Fed, the dialogue in the
investment community will be focused on when might the next cut
arrive. Versus if we don't get that rate cut in December, the
dialogue will focus on, maybe we will never see another rate cut
in the cycle. And what if we see a rate hike as we make our way
through the second half of 2026? So that can have a dramatic
impact on the U.S. Treasury market and how investors think about
the outlook for policy and the economy.
Michael Gapen: So, I think that's right. And as
you know, our baseline outlook is at least through the first
quarter, if not into the second quarter. The private sector will
still be attempting to pass through tariffs into prices. And I
think in the meantime, demand for labor and the hiring rate will
remain low.
And so, we look for additional labor market slack to build. Not a
lot, but the unemployment rate moving to more like 4.6, maybe 4.7
– and that underpins our expectation the Fed will be reducing
rates in in 2026. But I think as you note, and as I mentioned
earlier, there is this tension in the data and it's not
inconceivable that the labor market accelerates. And you get,
kind of, an animal spirits driven 2026; where a combination of
momentum in the data, AI-related business spending, wealth
effects for upper income consumers and maybe a larger fiscal
stimulus from the One Big Beautiful Bill Act, lead the economy to
outperform.
And to your point, if that is happening, it's not farfetched to
think, well, if the Fed put in risk management insurance cuts,
perhaps they need to take those out. And that could build in a
way where that expectation, let's say towards the second half or
the fourth quarter maybe of 2026, maybe it takes into 2027. But I
agree with you that if the Fed can't cut in December because the
economy's doing well and the data show that, and we learn more of
that in 2026, you're right.
So, it would… And may maybe to put it more simply, the more the
Fed cuts, the more you need to open both sides of the rate path
distribution, right? The deeper they cut, the greater the
probability over time, they're going to have to raise those
rates. And so, if the Fed is forced to stop in December, yeah,
you can make that argument.
Matthew Hornbach: Indeed, a lot of the factors
that you mentioned are factors that are coming up in investor
conversations increasingly. The way I've been framing it in my
discussions is that investors want to see the glass as half full
today, versus in the middle of this year the glass was looking
half empty. And of course, as we head into the holiday season,
the glass will be filled with something perhaps a bit tastier
than water. And so…
Michael Gapen: Fill my glass please.
Matthew Hornbach: Indeed. So, I do think that we
could be setting up for a bright 2026 ahead. And so, with that,
Mike, look forward to seeing you again in December – with a glass
of eggnog perhaps. And a decision in hand for the meeting that
the Fed holds then. Thanks for taking the time to talk.
Michael Gapen: Great speaking with you, Matt.
Matthew Hornbach: And thanks for listening. If
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