Weighing Fed Cut Against Jobs and Inflation Risks

Summary

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Episode Overview

Podcast: Thoughts on the Market
Title: Weighing Fed Cut Against Jobs and Inflation Risks
Air Date: September 18, 2025
Hosts: Matthew Hornbach (Global Head of Macro Strategy, Morgan Stanley) & Michael Gapen (Chief U.S. Economist, Morgan Stanley)

Theme:
This episode is a deep dive into the U.S. Federal Reserve’s decision to initiate its first quarter-point rate cut of 2025. Matthew and Michael dissect the Fed’s motivations, implications for the labor market and inflation, nuances in the Fed’s economic projections, and the market’s reaction and expectations moving forward.

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Key Discussion Points and Insights

1. Fed’s Motivation: Labor Market Risks and Policy Response

• Primary Reason for the Cut: The Fed's rate cut is largely a response to increased downside risks in the labor market, notably a recent slowdown in hiring, guided by risk management principles.
  • "The Fed is moving because it sees downside risk in the labor market. The August employment data revealed that the hiring rate took a large step down and stayed down." (Michael, 00:33)
• Not on a Pre-set Path, but Trend is Clear:
  • While Chair Powell emphasized data dependency and meeting-by-meeting decision-making, the “dot plots” (Fed officials’ rate forecasts) point towards an anticipated series of rate cuts.
    • "They’re not prepared to just do once and go, well, maybe, maybe we’ll go again, maybe we won’t. The dot plots clearly indicate a series of moves here…" (Michael, 01:18)
• Powell’s Own Words:
  • "When pressed on, well, what’s a 25 basis point rate cut going to do… Powell responded by, well, nothing. 25 basis points won’t really affect the macro outcome, but it’s the path that matters." (Michael, 01:38)
• Expectations for Number of Cuts: 2-3 more cuts suggested by the Fed’s projections for 2025.

2. Summary of Economic Projections: The Fed vs. Morgan Stanley

• Labour Market and Inflation Forecasts:
  • The Fed revised growth projections up, saw a lower unemployment rate for future years, and revised 2026 inflation higher.
  • The Fed appears "more tolerant" of higher inflation as a tradeoff for labor market support.
    • "They revised up growth. They have the unemployment rate path lower... and they revised inflation higher in 2026. That may seem at odds with what they're doing…" (Michael, 02:44)
• Morgan Stanley's Outlook Diverges:
  • The Morgan Stanley team is less optimistic about labor market strength, forecasting a weaker labor market into 2026.
    • "We're not quite as optimistic on the Fed as the Fed is on the economy. We do think the labor market weakens a little bit further into 2026." (Michael, 03:31)
  • They expect the Fed will ultimately need to bring rates closer to "neutral" than the Fed currently signals.
    • "Powell said we're moving, quote, in the direction of neutral. ... We think the Fed ultimately will have to do that, though they're not prepared to communicate that." (Michael, 04:09)

3. Unemployment Rate Projection and Policy Implications

• End-of-Year Numbers:
  • The Fed projects an average unemployment rate of 4.5% for Q4 2025, up from 4.3% currently.
• Rate Cut Projections for 2026:
  • Despite a rising unemployment rate, the Fed forecasts only one additional rate cut in 2026, a stance Michael finds hard to sustain if labor conditions remain soft.
    • "That's a challenging position to be in... the unemployment rate's risen about a half a percentage point from its lows... I would say they haven't seen a lot of evidence by December that inflation's coming back down and the labor market has stabilized." (Michael, 05:39)
  • Morgan Stanley anticipates more cuts to achieve a neutral stance amid sustained labor market weakness.

4. Market Reaction to the Fed’s Decision

• Immediate Response:
  • In the moments after the Fed's announcement, bond yields dropped and the yield curve steepened — a typical initial reaction to a dovish move.
  • As details were digested, sentiment moderated and interest rates rebounded, signaling a market view of a balanced risk assessment by the Fed.
    • "Initially we had yields coming down a bit, the yield curve steepened a bit, but then... it became clear... the delivery... was a bit more moderate... a fairly balanced assessment of where things are..." (Matthew, 07:07)
• Final Assessment:
  • Rates ended the day slightly higher, then moderated the following day, suggesting the market views the policy stance as "steady as they go."
    • "Interest rates ended up moving slightly higher towards the end of the day, but then the next day they came back a bit." (Matthew, 07:55)

5. Markets’ Expectations for Future Rate Cuts and the "Terminal Rate"

• Recalibration Debate:
  • Markets are pricing in the likelihood of consecutive rate cuts through year end, in line with Fed guidance.
  • Yet, both the Fed and market emphasize data dependency, so upcoming employment and inflation data could alter expectations for the October meeting and beyond.
    • "The markets are... not going to fully price in everything that the Fed is suggesting, both because the Fed may not end up delivering what it is suggesting it might or it may deliver more." (Matthew, 09:18)
• Divergence on "Terminal Rate":
  • Markets expect the Fed to ultimately cut rates below the levels in the Fed's "summary of economic projections," reflecting risk premia and skepticism about the Fed's current path.
    • "The market is pricing the trough policy rate for the Fed below where the summary of economic projections is suggesting, but that market pricing is more representative, I think, of a risk premium..." (Matthew, 09:48)

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Notable Quotes & Memorable Moments

• "We're not quite sure how to assess [the labor market], but when employment growth slows this much, we think we need to take notice." – Michael Gapen (00:43)
• "25 basis points won't really affect the macro outcome, but it's the path that matters." – Michael Gapen quoting Powell (01:38)
• "They are more tolerant of inflation as the cost or the byproduct of needing to lower rates to support the labor market." – Michael Gapen (03:05)
• "Powell said we're moving, quote, in the direction of neutral. So he's not committing to go all the way to neutral. And we're just saying we think the Fed ultimately will have to do that, although they're not prepared to communicate that." – Michael Gapen (04:09)
• "It very much seems a balanced assessment of the risks and I think as a result the market balanced out its initial euphoria about lower rates with a moderation of that view." – Matthew Hornbach (07:45)

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Timestamps for Important Segments

• 00:33 – Fed’s motivation for the rate cut; labor market signals
• 01:38 – Powell’s view: why path, not single cut, matters
• 02:44 – Fed’s projections vs. Morgan Stanley’s outlook
• 04:31 – Unemployment projections and rate cuts in 2026
• 05:39 – The challenge of balancing unemployment and inflation
• 07:07 – Immediate and broader market reaction
• 08:40 – Market pricing and outlook for further cuts
• 09:01–10:59 – Future outlook, data dependency, and divergence between market and Fed

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Conclusion

This episode offers a concise, insight-rich analysis of the Fed’s latest move to cut rates against a backdrop of labor market threats and inflation worries. The discussion explores the divergent outlooks of the Federal Reserve and Morgan Stanley, grapples with the practical implications for rate policy into 2026, and provides listeners with a nuanced read—straight from market strategists—on how both policy makers and investors are navigating an uncertain economic landscape.

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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]

Our topic today is the Fed's first quarter percent rate cut in 2025. We're here to discuss the implications and the path forward. It's Thursday, September 18th at 10:00am in New. So, Mike, the Fed concluded its meeting on Wednesday. What was the high level takeaway from your perspective?

[B]

So I think there's two main points here. There's certainly more that we can discuss. But two main takeaways for me are obviously the Fed is moving because it sees downside risk in the labor market. So the August employment data revealed that the hiring rate took a large step down and stayed down. Right. And the Fed is saying it's a curious balance in the labor market. We're not quite sure how to assess it, but when employment growth slows this much, we think we need to take notice. So they're adjusting their view. We'll call it risk management because that's what Powell said. And saying there's more risk of worse outcomes in the labor market. Keeping a restricted policy stance is inappropriate. We should cut. So that's part one. I think he previewed all of that in Jackson Hole. So it was largely the same. But it's important to know why the Fed's cutting. The second thing that was interesting to me is as much as he, Powell in this case tried to avoid the idea that we're on a preset path, that policy is always data dependent and it's always a meeting to meeting decision. We know that. But it does feel like if you're recalibrating your policy stance because you see more downside risk to the labor market, they're not prepared to just do once and go, well, maybe, maybe we'll go again, maybe we won't. The dot plots clearly indicate a series of moves here. And when pressed on, well, what's a 25 basis point rate cut going to do to help the labor market? Powell responded by, well, nothing. 25 basis points won't really affect the macro outcome, but it's the path that matters. So I do think, and I use the word recalibration, Powell didn't want to use that. I do think we're in for a series of cuts here. The median dot would say 3, but maybe to 2 to 3.75basis points by year end and then we'll see how the world evolves.

[A]

Speaking of the summary of economic projections, what struck you as being interesting about the set of projections that we got on Wednesday. And how does the Fed's idea of the path into 2026 differ from yours?

[B]

Yeah, well, it was a lot about downside risk to the labor market. But what did they do? They revised up growth. They have the unemployment rate path lower in the outer years of their forecast than they did before. So they didn't revise down this year, but they revised down subsequent years and they revised inflation higher in 2026. That may seem at odds with what they're doing with the policy rate currently. But my interpretation of that is the main point to your question is they're more toler tolerant of inflation as the cost or the byproduct of needing to lower rates to support the labor market. So if this all works, the outlook is a little stronger from the Fed's perspective. And so what's key to me is that they are, you know, the median of the forecast, to the extent that they align in a coherent message, are saying we're going to have to pay a price for this in the form of stronger inflation next year to support the labor market this year. So that means in their forecast cuts this year, but fewer cuts in 2026 and 27. And how that differs from our forecast is we're not quite as optimistic on the Fed as the Fed is on the economy. We do think the labor market weakens a little bit further into 2026. So you get four consecutive rate cuts upfront, again inclusive of the one we got on Wednesday, and then you get two additional cuts by the middle of 2026. So we're not quite as optimistic. We think the labor market's a little softer, and we think the Fed will have to get closer to neutral. Right. Powell said we're moving, quote, in the direction of neutral. So he's not committing to go all the way to neutral. And we're just saying we think the Fed ultimately will have to do that, although they're not prepared to communicate that.

[A]

Now, one of the things that struck me as interesting about the summary of economic projections was the unemployment rate projection for end of this year. So the way that the Fed delivers these projections is they give you a number on the unemployment rate that represents the average unemployment rate in the fourth quarter of the specified year. And in this case, the median FOMC participant is projecting that the unemployment rate will average 4.5%. And that's what we're forecasting as well, I believe. And so what struck me as interesting is that with an average unemployment rate of 4.5% in the fourth quarter of the year, which is up about 0.2% from today's unemployment rate of 4.3. The Fed is only projecting one additional rate cut in 2026. And I'm curious, do you think that if we in fact get to the end of this year and it looks like the unemployment rate has averaged about 4.5%, do you expect the Fed to continue to forecast only one rate cut in 2026?

[B]

Yeah, I think that's the short answer is no. I think that's a challenging position to be in. And by that I mean in addition to that unemployment rate forecast, where it's 4.5% for the average of the fourth quarter, which could mean December is as high as 4.6. We don't know what their monthly forecast is, but that would mean the unemployment rate's risen about a half a percentage point from its lows a few months ago. And they have inflation rising to 3%. Core PCE is already 2.9. So inflation is about where it is today, a touch firmer, but the unemployment rate has moved higher. And so what I would say is they haven't seen a lot of evidence by December that inflation's coming back down and the labor market has stabilized. So this is why we think they will be more likely to get to a neutral ish or something closer to neutral in 2026 than they're prepared to communicate now. So I think that's a good point. So, Matt, if I could turn it back to you, I would just like first to ask you about the general market reaction. The 25 basis point cut was universally expected, so really all the potentially new news was in about the forward path from here. So how did markets reply to this? Yields did initially sell off a bit, but they generally came back. What's your assessment of how the market took the decision?

[A]

Yeah, so the initial 5, 10 minutes after the statement and summary of economic projections is released, everybody's digesting all of the new information. And generally speaking, investors tend to see what they want to see initially and in all of the materials. So initially we had yields coming down a bit, the yield curve steepened a bit, but then about a half an hour later, it became clear, just right before the press conference had started, it became clear to people that actually this delivery in the documentation was a bit more moderate in terms of the forward look, that it was a fairly balanced assessment of where things are and where things may be heading in that in the end, the Fed, while it does want to bring interest rates lower at least in the modal case, that it is still not particularly concerned about downside risks to activity? I should say then it is concerned about upside risks to inflation. It very much seems a balanced assessment of the risks and I think as a result the market balanced out its initial euphoria about lower rates with a moderation of that view. So interest rates ended up moving slightly higher towards the end of the day, but then the next day they came back a bit. So I think it was a bit more of a steady as they go assessment from markets in the end.

[B]

And do you see markets as maybe changing their views on whether it is a recalibration in the stance, therefore we should expect consecutive cuts, or is the market now thinking, hey, maybe is meeting by meeting? And what about the Fed's forecast of its terminal rate versus the market's forecast of the terminal rate? So what, what happened there?

[A]

Indeed, yeah. So in terms of how market prices are incorporating the idea that the Fed may cut at consecutive meetings through the end of the year, I think markets are generally priced for an outcome about in line with that idea. But of course markets and investors who trade markets have to take into consideration the upcoming data. And with the Fed so data dependent, so meeting by meeting in terms of their decisions, it could certainly be the case that the next employment report and or the next inflation report could dissuade the committee from lowering rates again at the end of October when the Fed next meets. So I think the markets are, as you can expect, not going to fully price in everything that the Fed is suggesting, both because the Fed may not end up delivering what it is suggesting it might or it may deliver more. So the markets are clearly going to be data dependent as well in terms of how the market is pricing the trough policy rate for the Fed. It does expect that the Fed will take its policy rate below where the summary of economic projections is suggesting, but that market pricing is more representative, I think of a risk premium to the expectations of investors which generally are in line or end up moving in line with the summary of economic projections over time. So given that the Fed has changed the economic projections and the forecast for policy rates, investors probably also end up shifting a bit in terms of their own expectations. So with that Mike, I will bid you adieu until we speak again next time around the time of the October FOMC meeting. So 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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