Morgan Stanley Economists Predict Series of Fed Rate Cuts

Morgan Stanley economists have rapidly shifted their expectations for Federal Reserve rate cuts, forecasting in a new report to clients on Friday that the Fed will deliver four consecutive 25-basis-point rate cuts. The team of economists, led by Michael Gapen, stated that the details behind Thursday's Consumer Price Index (CPI) release were actually fairly benign. While core CPI rose 0.35% month-over-month in August, they estimate core Personal Consumption Expenditures (PCE) prices will rise only 0.18% month-over-month. Morgan Stanley now anticipates the Fed cutting rates more quickly, but their terminal rate expectations are consistent with prior forecasts. This shift in expectation is partly attributed to tariffs not being as impactful as feared.

Why This Matters: Understanding the trajectory of interest rates is crucial for businesses and consumers alike. Interest rates can influence borrowing costs, investment decisions, and the overall health of the economy.

"Lower-than-expected inflation perhaps gives the Fed more confidence that even in the face of tariff-driven pressures, inflation expectations remain anchored in a stable range," they said. This would allow the Fed to focus more on the softening labor market – not just the soft job growth, but also the small uptick in unemployment, declining manufacturing employment, and the job openings-to-unemployed ratio falling below 1. The Morgan Stanley team now anticipates four consecutive rate cuts, up from their prior forecast of three. The Morgan Stanley team expects the Fed to pause after these four cuts to judge how close the current rate is to the neutral rate, and then resume cuts in April and July of next year. The ultimate terminal rate target is unchanged, still expected to be between 2.75% and 3%.

Factors Influencing Fed Decisions:

• Inflation Data: The Fed closely monitors inflation metrics like the CPI and PCE to guide monetary policy decisions.
• Labor Market: The health of the labor market, including the unemployment rate and job growth, plays a significant role in determining the Fed's stance on interest rates.
• Global Economic Conditions: Global economic events and developments can impact the U.S. economy and influence the Fed's decisions.

The Morgan Stanley team also provided answers to two reasonable questions the report prompted. The first question is: Why not just start the new cycle with a 50-basis-point cut in September? "Because the unemployment rate remains relatively low and the fed funds rate has moved 100 basis points closer to neutral than it was last year. When policy is in moderately restrictive territory, gradual easing is more likely," they explained. The second question is: Why an extra cut in January of next year? "If only 75 basis points are delivered (i.e., three 25 bp cuts), the fed funds rate would still be slightly above the Fed's upper bound estimate of neutral," they responded. On Thursday, after the August CPI data and a report of rising initial jobless claims were released, the U.S. 2-year Treasury yield touched its third-lowest level of the year. Meanwhile, the S&P 500 made its 24th all-time high of the year.