Breaking Down the Fed’s New Course

Summary

Podcast Summary: "Breaking Down the Fed’s New Course"

Podcast: Thoughts on the Market
Episode Date: August 28, 2025
Hosts: Matthew Hornbach (Global Head of Macro Strategy) & Michael Gapen (Chief U.S. Economist, Morgan Stanley)

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Episode Overview

This episode dives into the surprises from Federal Reserve Chair Jerome Powell's comments at the latest Jackson Hole meeting. Matthew Hornbach and Michael Gapen analyze what the shift in tone means for future monetary policy, the path of interest rates, and broader economic risks. The conversation is wide-ranging, with a focus on the Fed’s new patient, risk-management posture and what this signals for markets in the months ahead.

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Key Discussion Points & Insights

1. The Jackson Hole Surprise and Powell’s New Language

• Jackson Hole’s Unexpected Tone

  • Both stocks and bonds reacted sharply to Chair Powell’s address.
  • Powell explicitly stated: “…with policy in restrictive territory, the baseline outlook for the shifting balance of risks may warrant adjusting our policy stance.”
  • This caught Hornbach's attention, signaling a potential shift in strategy.
  • [00:20]

• Interpretation of Powell’s Message

  • Gapen asserts, “It was a surprise to me and I think I would highlight three aspects of his Jackson Hole comments that were important to me.”
  • The Fed is now more concerned about downside risk to the labor market, potentially due to July’s employment report showing unexpected weakness.
  • The statement implies a pivot to “risk management mode” — possibly earlier and more gradual policy rate cuts to shore up the labor market.
  • [01:01]

2. Signals from the Fed: A Shift to Risk Management and Caution

• Policy Stance “Largely Made”

  • Gapen highlights the significance of Powell explicitly mentioning adjustment:
    • “When the Chair explicitly writes in a speech that the economy now may warrant adjustments in our policy stance, I mean, that's a big deal. It suggests that the decision has been largely made.”
    • Implies a series of moves, not just one cut.
    • [01:45]

• Proceed Cautiously—No Large Surprise Cuts

  • Powell’s phrase “proceed cautiously” is interpreted as a cue:
    • “Don't expect that this time around. The world's different. This is a risk management discussion. And so we think two rate cuts before year end would be most likely, maybe you get three. But I don't think we should expect a large 50 basis point cut at the September meeting.”
    • Compared to the previous year’s aggressive action, this signals a more tempered, patient approach.
    • [02:35]

3. Updating the Path: Gradual, Quarterly Cuts Through 2026

• Forecasted Trajectory
  • Gapen’s baseline: Quarterly 25 bp cuts—September and December this year, then March, June, September, and December next year (2026).
    • Terminal fed funds range forecasted at 2.75-3.00%, a 25 bp upward shift from previous projections.
    • “So rather than moving later and more rapidly, you move earlier but more gradually. That’s how we’re thinking about it now.”
    • [03:54 — 05:20]

4. Alternate Scenarios: What Could Go Differently?

• What Might Stop the Fed from Cutting in September?

  • A much stronger August jobs report could delay rate cuts:
    • “You'd need a—I think—a really strong August employment report, something around 225,000 jobs … That would be a signal that the May June downdraft was just a … pothole and not trend deterioration in the labor market.”
    • [06:09]

• Faster/Larger Cuts or On-Hold Periods Possible

  • Possibility of a repeat of last year—bigger initial cuts, pause, then resumption if needed.
  • The Fed may show greater tolerance for above-target inflation in a “risk management” posture, affecting the ultimate level and pace of cuts in 2026.
    • “So we could even see a deeper trough through greater inflation tolerance.”
    • [07:05]

• Recession Scenario: Deeper Cuts

  • In a downturn, policy could be even more accommodative:
    • “Of course, in a recession alternative scenario, the Fed’s probably cutting much deeper, maybe down to 150 to 175 on the funds rate.”
    • [07:48]

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Notable Quotes & Memorable Moments

• On the shift toward labor-market risk management:

  • Michael Gapen: “The July employment report told them perhaps there's more weakness in the labor market now than they thought. So I think the messaging here is about a shift towards risk management mode. Maybe we need to put in a couple policy rate cuts to shore up the labor market.”
  • [01:12]

• On the Fed’s new communication:

  • Michael Gapen: “When the Chair explicitly writes in a speech that the economy now may warrant adjustments in our policy stance, I mean, that's a big deal. It suggests that the decision has been largely made.”
  • [01:45]

• On approaching policy with caution:

  • Michael Gapen: “The phraseology proceeds carefully is a signal to markets that, hey, don't expect that this time around… This is a risk management discussion.”
  • [02:54]

• On the path ahead:

  • Michael Gapen: “So rather than moving later and more rapidly, you move earlier but more gradually. That's how we're thinking about it now.”
  • [05:14]

• Contingency thinking:

  • Michael Gapen: “As we like to say in economics, we forecast so we know where we're wrong.”
  • [06:11]

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Important Timestamps

• 00:20 – Introduction of the Jackson Hole surprise
• 01:12 – Fed’s pivot to worry about labor market downside
• 01:45 – Powell’s policy adjustment language significance
• 02:35 – Interpretation of “proceed cautiously”
• 03:54 – Gapen lays out baseline rate cut forecast
• 05:14 – Discussion of more gradual approach and impact on terminal rate
• 06:09 – Alternative scenarios: what would delay or change the forecast
• 07:48 – Recession scenario and much lower potential policy rates

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Tone and Delivery

Throughout, the episode maintains an analytical, calm, and data-driven tone. The hosts use measured language, acknowledging inherent uncertainty (“we forecast so we know where we’re wrong”) and emphasizing patience and incrementalism as the Fed shifts course.

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This part one episode sets the table for further analysis in part two, where the focus will shift to market reaction, interest rates, and the US dollar post–Jackson Hole.

Transcript

[A]

Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy.

[B]

And I'm Michael Gapen, Morgan Stanley's chief U.S. economist.

[A]

Last Friday, the Jackson Hole meeting delivered a big surprise to markets. Both stocks and bonds reacted decisively today, the first of a two part episode. We'll discuss Michael's reaction to Chair Powell's Jackson Hole comments and what they mean for his view on the outlook for monetary policy tomorrow, the outlook for interest rate markets and the US dollar. It's Thursday, August 28th at 10:00am in New York. So Mike, here we are after Jackson Hole. The mood this year felt a lot more hawkish, or at least patient than what we saw last week. And Chair Powell really caught my attention when he said, with policy in restrictive territory, the baseline outlook for the shifting balance of risks may warrant adjusting our policy stance. That line has been on my mind ever since. So let's dig into it. What's your gut reaction?

[B]

Matt? It was a surprise to me and I think I would highlight three aspects of his Jackson Hole comments that were important to me. So I think what happened here, of course is the Fed became much more worried about downside risk to the labor market after the July employment report. At the July FOMC meeting which came before that report, Powell had said, well, you know, slow payroll growth is fine as long as the unemployment rate stays low. And that's very much aligned with our view. But sometimes these things are easier said than done. And I think the July employment report told them perhaps there's more weakness in the labor market now than they thought. So I think the messaging here is about a shift towards risk management mode. Maybe we need to put in a couple policy rate cuts to shore up the labor market. And I think that was the big change. And I think that's what drove the overall message in the statement. But there were two other parts of it that I think were interesting from the economist's point of view. When the Chair explicitly writes in a speech that the economy now may warrant adjustments in our policy stance, I mean, that's a big deal. It suggests that the decision has been largely made. And I think anytime the Fed is taking a change of direction, either easing or tightening, they're not just going to do one move. So they're signaling that they're likely prepared to do a series of moves and we can debate about what that means. And then third thing that struck me is right before the line that you mentioned, he did qualify the need to adjust rates by saying, well, whatever we do, we should proceed Cautiously. So a year ago, as you recall, the Fed opened up with a big 50 basis point rate cut, which was a surprise, and cut at three successive meetings. So 100 basis points of cuts over three meetings starting with a 50 basis point cut. I think the phraseology proceeds carefully is a signal to markets that, hey, don't expect that this time around the world's different. This is a risk management discussion. And so we think two rate cuts before year end would be most likely, maybe you get three. But I don't think we should expect a large 50 basis point cut at the September meeting. So those would be my thoughts. Downside risk to the labor market. Putting this into words says something important to me. And the proceed cautiously language, I think is something markets also need to take into account.

[A]

So how do you translate that into a forecasted path for the Fed? I mean, in terms of your baseline outlook, how much rate cuts are you forecasting this year? And what about in 2026?

[B]

Right. So we previously we thought what the Fed was doing was leaning against risks that inflation would be persistent. They moved into that camp because of how fast tariffs were going up and the overall level of the effective tariff rate. So we thought they would stay on hold for longer and when they move, move more rapidly. What they're saying now in a risk management sense, Right. They still think risk to inflation's to the upside, but the unemployment rate is also to the upside. And they're looking at both of those as about equally weighted. So in a baseline outlook where the Fed's not assuming a recession and neither are we, you get maybe a dip in growth and a rise in inflation, but growth recovers and inflation comes down next year in that world. And with the idea that you're proceeding cautiously, they're kind of moving and evaluating, moving and evaluating. So I think the translation here is a path of quarterly rate cuts between now and the end of 2026, so six rate cuts, but moving quarterly, like September and December this year, March June, September and December next year, which would take us to a terminal target range of 275 to 3. So rather than moving later and more rapidly, you move earlier but more gradually. That's how we're thinking about it now.

[A]

And that's about a 25 basis point upward adjustment to the trough policy rate that you were forecasting previously.

[B]

That's right. So the prior thought was the Fed that moves later may have to cut more. Right. Because by holding policy tighter for longer, you're putting more downward weight on the economy from a cyclical perspective. So you may end up cutting more to essentially reverse that in 2020. Earlier maybe a Fed that moves a little earlier cuts a little less.

[A]

In terms of the alternative outcomes, obviously in any given forecast things can go not as expected. And so if the path turns out to be something other than what you're forecasting today, what would be some of the more likely outcomes in your mind?

[B]

Yeah, as we like to say in economics, we forecast so we know where we're wrong. So you're right, the world can evolve very differently. So just a couple thoughts, you know, one, now that we're thinking the Fed does cut in September, what gets them not to cut? You'd need a, I think a really strong August employment report, something around 225,000 jobs, which would bring the three month moving average back to around 150. Right. That would be a signal that the May June downdraft was just a post Liberation Day pothole and not trend deterioration in the labor market. So that would be one potential alternative. Another is, although we've projected quarterly paths in this kind of nice gradual pace of cuts, we could get a repeat of last year where The Fed cuts 50 to 75 basis points by year end, but realizes the labor market has not rolled over. And then we get some tariff pass through into inflation and maybe residual seasonality and inflation in Q1, and then the Fed goes on hold again. Then cuts could resume later in the year. And I also think in the backdrop here when the Fed is saying we are easing in a risk management sense and we're easing maybe earlier than we otherwise would, that suggests the Fed has greater tolerance for inflation. So understanding how much tolerance this Fed or the next one has for above target inflation I think could influence how many rate cuts you eventually get in in 2026. So we could even see a deeper trough through greater inflation tolerance. And finally, of course, we're not out of the woods with respect to recession risk. We could be wrong. Maybe the labor market is trend weakening and we're about to find that out growth is slowing. Growth was about 1.3% in the first half of the year. Final sales are softer. Of course, in a recession alternative scenario, the Fed's probably cutting much deeper, maybe down to 150 to 175 on the funds rate. So I mean, Matt, you make a good point. There's still many different ways the economy can evolve and many different ways that the Fed's path for policy rates can evolve.

[A]

Well, that's a good place to bring this part one episode to an end. Tune in tomorrow for my reaction to the market price action that followed Chair Powell's speech and what it means for our outlook for interest rate markets and the US Dollar. Mike, thanks for taking the time to talk. Great speaking with you, Matt, and thanks for listening. If you enjoy thoughts on the market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.

[C]

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