Podcast Summary: "Why the Fed Will Cut Late, But Cut More"
Hosted by Morgan Stanley
Release Date: June 26, 2025

Thoughts on the Market, hosted by Morgan Stanley, delves into the latest developments in the financial markets with insights from industry experts. In the episode titled "Why the Fed Will Cut Late, But Cut More," Matthew Hornbach, Morgan Stanley's Global Head of Macro Strategy, engages in a comprehensive discussion with Michael Gapen, the firm's Chief U.S. Economist. The conversation centers around the outcomes of the June Federal Open Market Committee (FOMC) meeting and explores expectations for interest rates, inflation, and the U.S. dollar.

1. FOMC Meeting Outcomes and Interest Rate Projections

The episode begins with an overview of the recent FOMC meeting, where the Federal Reserve decided to hold the federal funds rate steady within the target range of 4.25% to 4.5%. Despite maintaining current rates, the Fed anticipates two rate cuts by the end of 2025, with expectations of fewer cuts in 2026 and 2027.

Michael Gapen elaborates on Morgan Stanley's perspective, stating:

"We think the Fed will stay on hold for the rest of this year, with a lot of cuts to follow in 2026."
— [00:58]

Gapen outlines three primary reasons underpinning Morgan Stanley's view that the Federal Reserve will eventually implement more significant rate cuts:

2. Key Factors Influencing Rate Cuts

a. Tariffs and Economic Impact

Tariffs are a significant factor affecting the economy, introducing differential timing effects. Initially, tariffs push inflation higher by increasing prices, effectively acting as a tax on consumption. Over time, this leads to reduced consumer spending as real income declines.

"We think the Fed will be seeing more inflation first before it sees the weaker labor market later."
— Michael Gapen, [00:58]

Gapen emphasizes that the Fed is likely to encounter increased inflation before the labor market experiences a slowdown, aligning with Morgan Stanley's forecasts.

b. Immigration Controls and Labor Market Dynamics

Changes in immigration policy have led to a substantial reduction in annual immigration from approximately 3 million to 300,000 individuals. This slowdown in labor force growth makes it challenging to increase the unemployment rate, even as economic conditions weaken.

"The unemployment rate is likely to remain low."
— Michael Gapen, [01:30]

This dynamic means that the Fed may continue to face inflationary pressures while the labor market remains robust, necessitating eventual rate cuts to sustain economic stability.

c. Fiscal Policy Implications

Morgan Stanley does not anticipate a significant boost from fiscal policy based on the current legislative environment. The fiscal measures under consideration do not appear poised to provide a substantial impetus for economic growth in the coming year.

"We don't really expect a big impulse from fiscal policy."
— Michael Gapen, [01:50]

3. Federal Reserve’s Stance on Tariffs

The conversation shifts to the Federal Reserve's messaging regarding tariffs, which were highlighted approximately 30 times during the press conference transcript analyzed by Matthew Hornbach.

"The Fed’s outlook has actually moved more in the direction of our own forecasts."
— Michael Gapen, [04:36]

Gapen notes that the Fed has incorporated tariffs significantly into their economic forecasts, leading to revised expectations:

• Inflation Expectations: The Fed has raised its headline and core Personal Consumption Expenditures (PCE) inflation forecasts to about 3% and 3.1%, respectively, up from earlier estimates.

• Growth Projections: The Fed anticipates slowed economic growth, attributing part of this outlook to the effects of tariffs.

Despite recognizing higher inflation in the near term, the Fed maintains that this inflation is transitory, with expectations to return to the 2% target by 2026 and 2027.

4. Geopolitical Factors: Middle East and Oil Prices

Addressing geopolitical concerns, particularly the Middle East conflict and its potential impact on oil prices, Gapen provides insights into how these factors might influence the Fed's policies and the broader economy.

"It's another force that suggests a slower growth, stickier inflation outlook is likely to prevail."
— Michael Gapen, [05:02]

Gapen explains that a significant rise in oil prices, driven by geopolitical tensions, could lead to higher headline inflation without substantially affecting core inflation. Increased gasoline prices would reduce consumer purchasing power, further slowing economic growth.

5. Market Pricing vs. Morgan Stanley’s Forecasts

Matthew Hornbach contrasts the current market pricing of the Fed's policy path with Morgan Stanley's projections. While the market collectively anticipates around 100 basis points of rate cuts by the end of 2026 and includes some rate cuts within the current year, Morgan Stanley forecasts a more aggressive 175 basis points of rate cuts starting in 2026, with no cuts expected this year.

"The market is only pricing in 100 [basis points], but we are forecasting 175 basis points of rate cuts."
— Matthew Hornbach, [06:25]

This discrepancy highlights a divergence in expectations between market participants and Morgan Stanley's economic outlook.

6. Treasury Yields Forecast

The discussion moves to treasury yields, with Morgan Stanley projecting a decline beginning in the fourth quarter of the year. This projection aligns with the anticipated timing of rate cuts by the Fed in the first quarter of the next year. Stark differences in treasury yield movements are expected compared to recent trends.

"We expect treasury yields to begin falling more precipitously than they have over recent months."
— Matthew Hornbach, [07:26]

Gapen concurs, emphasizing that the primary conviction lies in the direction of treasury yields, recommending that investors prepare for lower yields in the near future.

7. U.S. Dollar Outlook Amid Geopolitical Tensions

Finally, the conversation addresses the U.S. dollar's trajectory in light of potential oil price spikes due to Middle East conflicts. Morgan Stanley projects a continued depreciation of the dollar by approximately 10% over the next 12 to 18 months, building on a similar 10% decline in the first half of the year.

"We are projecting the US dollar will depreciate another 10% over the next 12 to 18 months."
— Matthew Hornbach, [09:14]

While a significant rise in crude oil prices could temporarily slow the dollar's depreciation, the overall trend remains bearish. The neutrality of the U.S. in oil import/export dynamics mitigates substantial currency shifts, favoring a gradual decline.

Conclusion

The episode "Why the Fed Will Cut Late, But Cut More" provides a nuanced analysis of current economic indicators and policy directions. Morgan Stanley's insights, delivered by Matthew Hornbach and Michael Gapen, suggest a forthcoming period of rate cuts driven by persistent inflationary pressures from tariffs and constrained labor market growth due to immigration policies. Additionally, geopolitical factors and their impact on oil prices play a pivotal role in shaping expectations for treasury yields and the U.S. dollar. Investors are advised to prepare for a landscape characterized by lower treasury yields and a depreciating dollar in the coming months.

This summary encapsulates the key discussions and insights from the Morgan Stanley podcast episode, providing a comprehensive overview for those who have not listened to the original content.