Fed Signals Inflation Fight Isn’t Over

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.

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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.

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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.

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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]

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

[B]

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

[A]

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]

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]

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

[B]

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]

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]

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?

[A]

Yeah. So we came into this meeting advocating for a neutral stance in the bond market. We had seen a market pricing that ended up being more in line with the outcome of the meetings. We didn't expect yields to fall dramatically in the wake of this meeting, and we didn't expect yields to rise dramatically in the wake of this meeting. What we ended up seeing in the marketplace was higher yields as a result of a policy projection that I think surprised investors somewhat. And now the market is pricing an outlook that is somewhat similar to how the Fed is forecasting or projecting their policy rate into the future. In terms of our treasury yield forecasts, we didn't see anything in that meeting that changes the outlook for treasury markets all of that much, as you said, Mike, that in 2026, we're expecting much lower policy rates and that ultimately is going to weigh on treasury yields. As we make our way through the course of 2025, when we forecast market rates or prices, we have to think about where we are going to be in the future and how we're going to be thinking about the future from then. And so when we think about where are treasury yields going to be at the end of 2025, we need to try to invoke the views of investors at the end of 2025, which of course are going to be looking out into 2026. So when we consider the rate policy path that you're projecting at the moment and the factors that are driving that rate policy projection, slower growth, for example, a bit more moderate inflation. We do think that investors will be looking towards investing in the government bond market as we make our way through next year, because 2026 should be even more supportive of government bond markets than perhaps the economy and Fed policy might be in 2025. So that's how we think about the interest rate marketplace. We continue to project a 10 year treasury yield of just about 3.5% at the end of 2025. That does seem a ways away from where we are today with the 10 year treasury yield closer to 4.5%. But a year is a long time and that's plenty of time, we think, for yields to move lower gradually as policy does as well. On the foreign exchange side, the dollar we are projecting to soften next year and this would be in line with our view for lower treasury yields for the time being. The dollar reacted in a very positive way to the FOMC meeting this week. But we think in 2025 you will see some softening in the dollar and that primarily occurs against the Australian dollar, the euro as well as the yen. We are projecting the dollar yen exchange rate to end next year just below 140, which is going to be quite a move from current levels. But we do think that a year is plenty of time to see the dollar depreciate and that again links up very nicely with our forecast for lower treasury yields. Mike, with that said, one more question for you if you would. Where do things stand with inflation now and how does this latest FOMC signal? How does it relate to inflation expectations for the year ahead?

[B]

So right now inflation has been a little bit stronger than we and I think the Fed had anticipated. And that's coming from two sources. One, hurricane related effects on car prices. So the need to replace a lot of cars has pushed new and used car prices higher. We think that's a temporary story that's likely to reverse in the coming months. The more longer term concern has been around housing related inflation or what we would call shelter inflation. The good news in that is in November it took a market step lower. So I do think it tells us that that component which has been holding up inflation will continue to move down. But as we look ahead to your point about inflation expectations, the real concern here is about potential shifts in policy, maybe the implementation of tariffs, the restriction of immigration. We as economists would normally say those should have level effects or one off effects on inflation. And normally I'd have a high confidence in that statement. But we just came out of a very prolonged period of higher than normal inflation. So I think the concern is repetitive. One off shocks to inflation lead inflation expectations to move higher. Now we don't think that will happen. Our outlook is for rate cuts, but this is the concern. So we think inflation moves lower but we're certainly watching the behavior of inflation expectations to see if our forecast is misguided.

[A]

Well, great, Mike, thanks so much for taking the time to talk.

[B]

Great speaking with you, Matt, and thanks for listening.

[A]

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[C]

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