Fed Signals Inflation Fight Isn’t Over - Thoughts on the Market

Summary

Thoughts on the Market: Fed Signals Inflation Fight Isn’t Over

Released on December 19, 2024

In the latest episode of Morgan Stanley's "Thoughts on the Market," hosts Matthew Hornbach, Global Head of MacroStrategy, and Michael Gapen, Chief U.S. Economist, delve into the recent Federal Open Market Committee (FOMC) meeting and its implications for future monetary policy. Titled "Fed Signals Inflation Fight Isn’t Over," the episode provides insightful analysis on the Federal Reserve's stance on interest rate adjustments, inflation trends, and the broader economic outlook.

1. Fed's Latest Rate Cut and Projections

The episode begins with an overview of the FOMC's recent decision to cut interest rates by a quarter of a percentage point, marking the third rate cut of the year. Host Matthew Hornbach notes, "The FOMC meeting concluded yesterday with the Federal Reserve cutting rates by a quarter of a percentage point, marking the third rate cut for the year" (00:08). This move was largely anticipated by market consensus. However, the Fed signaled a more restrained approach to rate cuts in the upcoming years than investors had expected.

2. Factors Influencing Fed's Rate Cut Decisions

Michael Gapen sheds light on the factors driving the Fed's cautious outlook. He explains, "Chair Powell mentioned ... many committee members saw recent firmness in inflation as a surprise" (01:27). This unexpected resilience in inflation has led the Fed to reassess its rate-cut trajectory. Additionally, potential shifts in policy areas such as tariffs and immigration could introduce further inflationary pressures, prompting the Fed to maintain a higher bar for reducing rates.

3. Morgan Stanley's Revised Expectations

Responding to the Fed's updated projections, Gapen discusses Morgan Stanley's adjusted outlook. He states, "We previously thought the Fed would be cutting rates three times next year ... but we have to listen to what they're thinking..." (02:32). Consequently, Morgan Stanley has revised its forecast, anticipating only two rate cuts in 2025 and maintaining a more optimistic stance on rate reductions in 2026, driven by expected economic slowdowns from policy changes.

4. Impact on Treasury Yields and Foreign Exchange

Matthew Hornbach provides an analysis of how the Fed's signal has influenced treasury yields and the foreign exchange market. He observes, "We ended up seeing higher yields as a result of a policy projection that I think surprised investors somewhat" (03:51). Morgan Stanley projects the 10-year treasury yield to decline to approximately 3.5% by the end of 2025 from the current 4.5%. Additionally, the dollar is expected to soften in 2025, with the dollar-yen exchange rate forecasted to end the year just below 140, reflecting a potential depreciation aligned with lower treasury yields.

5. Current Inflation Trends and Future Expectations

The discussion turns to the state of inflation, with Gapen addressing both short-term and long-term factors. He notes, "Inflation has been a little bit stronger than we and I think the Fed had anticipated" (07:31). Short-term inflationary pressures stem from hurricane-related disruptions affecting car prices, which are likely temporary. However, shelter inflation remains a more persistent concern, although recent data indicates a downward trend. The interplay between these factors and potential policy changes will be crucial in shaping inflation expectations moving forward.

6. Conclusions and Forward-Looking Insights

As the episode concludes, both hosts emphasize the importance of monitoring inflation expectations and the Fed's policy responses. Gapen remarks, "We think inflation moves lower but we're certainly watching the behavior of inflation expectations to see if our forecast is misguided" (08:57). Hornbach reinforces the notion that while immediate impacts are manageable, the longer-term trajectory will depend heavily on evolving economic conditions and policy decisions.

Key Takeaways:

Fed's Rate Cuts: The Federal Reserve has initiated its third rate cut of the year by reducing rates by 0.25%, with indications of a slower pace of cuts in 2025 and 2026.
Inflation Resilience: Unexpected firmness in inflation and potential policy-induced inflationary risks have influenced the Fed to adopt a more cautious approach to rate reductions.
Morgan Stanley's Outlook: Adjustments have been made to anticipate two rate cuts in 2025, with optimism for further cuts in 2026 based on expected economic slowdowns.
Treasury Yields and Forex: Treasury yields are projected to decrease by the end of 2025, and the dollar is expected to weaken against major currencies, particularly the yen.
Inflation Dynamics: While short-term factors like hurricane-related disruptions impact inflation, shelter costs remain a long-term concern, albeit showing signs of easing.

This comprehensive analysis provides listeners with a nuanced understanding of the current monetary policy landscape, inflation trends, and their implications for various financial markets. For those who missed the episode, it offers a clear and detailed overview of the critical discussions shaping the market's outlook.

Speakers:

Matthew Hornbach: Global Head of MacroStrategy, Morgan Stanley
Michael Gapen: Chief U.S. Economist, Morgan Stanley

Notable Quotes:

"The FOMC meeting concluded yesterday with the Federal Reserve cutting rates by a quarter of a percentage point, marking the third rate cut for the year." — Matthew Hornbach (00:08)
"Chair Powell mentioned ... many committee members saw recent firmness in inflation as a surprise." — Michael Gapen (01:27)
"We are a little more comfortable with inflation than the Fed appears to be." — Michael Gapen (02:32)
"We ended up seeing higher yields as a result of a policy projection that I think surprised investors somewhat." — Matthew Hornbach (03:51)
"Inflation has been a little bit stronger than we and I think the Fed had anticipated." — Michael Gapen (07:31)

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Transcript

A (0:00)

Welcome to Thoughts on the Market. I'm Matthew Hornbach, global head of MacroStrategy.

B (0:04)

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

A (0:08)

Today we're going to talk about the Federal Open Market Committee meeting and the path for rates from here. It's Thursday, December 19th at 10am in New York. The FOMC meeting concluded yesterday with the Federal Reserve cutting rates by a quarter of a percentage point, marking the third rate cut for the year. This move by the Fed was just as the consensus had anticipated. However, in its meeting yesterday, the Fed indicated that 2025 rate cuts would happen at a slower pace than investors were expecting. So, Mike, what are committee members projecting in terms of upcoming rate cuts in 2025 and 2026?

B (0:50)

Matt, the Fed dialed back its expectations for policy rate easing in both 2025 and 2026. They now only look for two rate cuts. So 50 basis points worth of cuts in 2025, which would bring the funds rate to 3.9% and then only another 50 basis points in 2026, bringing the policy rate to 3.4%. So a major dialing back in their expectations of rate cuts over the next two years.

A (1:19)

What are the factors that are driving what now appears to be a slightly less do of the policy rate?

B (1:27)

Chair Powell mentioned I think two things that were really important. One, he said that many committee members saw recent firmness in inflation as a surprise. And so I think some FOMC members extrapolated that strength in inflation going forward and therefore thought fewer rate cuts were appropriate. But Chair Powell also said other FOMC members incorporated expectations about potential changes in policy, which we infer to mean changes about tariffs, immigration policy, maybe additional fiscal spending. And so whether they baked that in as explicit assumptions or just saw it as risks to the outlook, I think that these were the two main factors. So either just momentum in inflation or views on policy rate changes which could lead to to greater inflation going forward.

A (2:20)

So, Mike, what were your expectations going into this meeting and how did yesterday's outcome change Morgan Stanley's outlook for Federal Reserve policy next year and the year thereafter?

B (2:32)

We are a little more comfortable with inflation than the Fed appears to be. So we previously thought the Fed would be cutting rates three times next year and doing all of that in the first half of the year. But we have to listen to what they're thinking and, and it appears that the bar for rate cuts is higher. In other words, they may need more evidence to reduce policy rates. One month of inflation isn't going to do it, for example. So what we did is we took one rate cut out of the forecast for 2025. We now only look for two rate cuts in 2025, one in March and one in June. As we look into 2026, we do think the effect of higher tariffs and restrictions on immigration policy will slow the economy more. So we continue to look for more rate cuts in 2026 than the Fed is projecting. But obviously 2026 is a long way away. So, in short, Matt, we dialed back our assumptions for policy rate easing to take into account what the Fed appears to be saying about a higher bar for comfort on inflation before they ease again. So, Matt, if I can actually turn it back to you, how, if at all, did yesterday's meeting and what Chair Powell said, change some of your key forecasts?