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.

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)

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)

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

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.