Why the Fed Will Cut Late, But Cut More

Summary

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.

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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.

Transcript

[Matthew Hornbach]

Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global head of Macro Strategy.

[Michael Gapen]

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

[Matthew Hornbach]

Today we're discussing the outcome of the June Federal Open Market Committee meeting and our expectations for rates, inflation and the US dollar. From here, it's Thursday, June 26th at 10:00am in New York. Mike the Federal Reserve decided to hold the federal funds rate steady, remaining within its target range of four and a quarter to four and a half percent. It still anticipates two rate cuts by the end of 2025, but participants adjusted their projections further out, suggesting fewer cuts in 2026 and 2027. You, on the other hand, continue to think the Fed will stay on hold for the rest of this year, with a lot of cuts to follow in 2026. What specifically is behind your view, and are there any underappreciated dynamics here?

[Michael Gapen]

So we've been highlighting three reasons why we think the Fed will cut late but cut more. The first is tariffs introduce differential timing effects on the economy. They tend to push inflation higher in the near term and they weaken consumer spending with a lag. If Tariffs act is a tax on consumption, that tax is applied by pushing prices higher. And then only subsequently do consumers spend less because they have less real income to spend. So we think the Fed will be seeing more inflation first before it sees the weaker labor market later. The second part of our story is immigration. Immigration controls mean it's likely to be much harder to push the unemployment rate higher. That's because when we go from about 3 million immigrants per year down to about 300,000, that means much slower growth in the labor force. So even if the economy does slow and labor demand moderates, the unemployment rate is likely to remain low. So again, that's similar to the tariff story, where the Fed's likely to see more inflation now before it sees a weaker labor market later. And third, we don't really expect a big impulse from fiscal policy. The bill that's passed the House and is sitting in the Senate. We'll see where that ultimately ends up. But the details that we have in hand today about those bills don't lead us to believe that we'll have a big impulse or big boost to growth from fiscal policy next year. So in total, the Fed will see a lot of inflation in the near term and a weaker economy as we move into 2026. So the Fed will be waiting to ensure that that inflation impulse is indeed transitory. But a Fed that cuts late will ultimately end up Cutting more. So we don't have rate hikes this year, Matt, as you noted, but we do have 175 basis points in rate cuts next year.

[Matthew Hornbach]

So, Mike, looking through the transcript of the press conference, the word tariffs was used almost 30 times. What does the Fed's messaging say to you about its expectations around tariffs?

[Michael Gapen]

It does look like in this meeting participants did take a stand that tariffs were going to be higher and they likely proceeded under the assumption of about a 14% effective tariff rate. So I think you can see three imprints that tariffs have on their forecast. First, they're saying that inflation moves higher. And in the press conference Powell said explicitly that the Fed thinks inflation will be moving higher over the summer months. And they revised their headline and core PCE forecast higher to about 3% and 3.1%. Significant upward revisions from where they had things earlier in the year in March before tariffs became clear. The second component here is the Fed thinks any inflation story will be transitory. Famous last words of course. But the Fed forecasts that inflation will fall back towards the 2% target in 2026 and 2027. So near term impulse that fades. And third, the Fed sees tariffs as slowing economic growth. The Fed revives lower its outlook for growth in real GDP this year. So in sum, by incorporating tariffs and putting such a significant imprint on the forecast, the Fed's outlook has actually moved more in the direction of our own forecasts.

[Matthew Hornbach]

I'd like to stay on the topic of geopolitics. In contrast to the word tariffs, the words Middle east only was mentioned three times during the press conference with the weekend events there. Investor concerns are growing about a spike in oil prices. How do you think the Fed will think about any supply driven rise in energy commodity prices here?

[Michael Gapen]

I think the Fed will view this as another element that suggests slower growth and stickier inflation. I think it will reinforce the Fed's view of what tariffs and immigration controls due to the outlook. Because historically when we look at shocks to oil prices in the U.S. if you get about a 10% rise in oil prices from here, like another $10 increase in oil prices, history would suggest that will move headline inflation higher because it gets passed directly into retail gasoline prices. So maybe a 30 to 40 basis point increase in a year on year rate of inflation. But the evidence also suggests very limited second round effects and almost no change in core inflation. So you get a boost to headline inflation but no persistence elements. Very similar to what the Fed thinks tariffs will do. And of course the higher cost of gasoline will eat into Consumer purchasing power. So on that, I think it's another force that suggests a slower growth, stickier inflation outlook is likely to prevail. Okay, Matt, you've had me on the hot seat. Now it's your turn. How do you think about the market pricing of the Fed's policy path from here? It certainly seems to conflict with how I'm thinking about the most likely path.

[Matthew Hornbach]

So when we look at market prices, we have to remember that they are representing an average path across all various paths that different investors might think are more likely than not. So the market price today has about 100 basis points of cuts by the end of 2026. That contrasts both with your path in terms of magnitude. You are forecasting 175 basis points of rate cuts. The market is only pricing in 100. But also the market pricing contrasts with your policy path in that the market does have some rate cuts in the price for this year, whereas your most likely path does not. So that's how I look at the market price. The question then becomes where does it go to from here? And that's something that we ultimately are incorporating into our forecasts for the level of treasury yields.

[Michael Gapen]

Right. So turning to that, so moving a little further out the curve into those longer dated treasury yields, what do you think about those? Your forecast suggests lower yields over the next year and a half. When do you think that process starts to play out?

[Matthew Hornbach]

So in our projections, we have treasury yields moving lower, really beginning in the fourth quarter of this year. And that is to align with the timing of when you see the Fed beginning to lower rates, which is in the first quarter of next year. So market prices tend to get ahead of different policy actions, and we expect that to remain the case this year as well. As we approach the end of the year, we're expecting treasury yields to begin falling more precipitously than they have over recent months. But what are the risks around that projection? In our view, the risks are that this process starts earlier rather than later. In other words, we where we have most conviction in our projections is in the direction of travel for treasury yields, as opposed to the timing of exactly when they begin to fall. So we are recommending that investors begin gearing up for lower treasury yields even today. But in our projections, you'll see our numbers really begin to fall in the fourth quarter of the year, such that the 10 year treasury yield ends this year around 4% and it ends 2026 closer to 3%.

[Michael Gapen]

And these days it's really impossible to talk about movements in treasury yields without thinking about the US Dollar. So how are you thinking about the dollar amidst the conflict in the Middle east and your outlook for treasury yields?

[Matthew Hornbach]

So we are projecting the US dollar will depreciate another 10% over the next 12 to 18 months. That's coming on the back of a pretty dramatic decline in the value of the dollar in the first six months of this year, where it also declined by about 10% in terms of its value against other currencies. So we are expecting a continued depreciation and the conflict in the Middle east and what it may end up doing to the energy complex is a key risk to our view that the dollar will continue to depreciate if we end up seeing a dramatic rise in crude oil prices. That rise would end up benefiting countries and the currencies of those countries who are net exporters of oil, and may end up hurting the countries and the currencies of the countries that are net importers of oil. The good news is that the United States doesn't really import a lot of oil these days, but neither is it a large net exporter either. So the US in some sense turns out to be a bit of a neutral party in this particular issue. But if we see a rise in energy prices that could benefit other currencies more than it benefits the US Dollar, and therefore we could see a temporary reprieve in the dollar's depreciation, which would then push our forecast perhaps a little bit further into the future. So with that, Mike, thanks for taking the time to talk.

[Michael Gapen]

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

[Matthew Hornbach]

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