Morgan Stanley is standing by its projection that the Federal Reserve will hold interest rates unchanged through year-end, while also warning of clear contingencies that could prompt a change of course.
In a client note, analyst Michael Gapen said incoming data since the June Federal Open Market Committee meeting have made the bank "marginally more comfortable" with a no-hike baseline. He pointed to falling oil prices following the U.S.-Iran memorandum of understanding and an expectation that tariff pass-through is ending as reasons that reduce near-term upward pressure on inflation.
The firm projects fourth-quarter headline and core personal consumption expenditures inflation of 3.2% and 3.0%, respectively, describing those figures as "substantially below the median FOMC participant." On month-to-month dynamics, Morgan Stanley expects monthly core PCE and CPI readings of 0.2% or below in the coming months.
Turning to the labour market, the bank anticipates relatively modest payroll gains over the summer, forecasting 50,000 to 60,000 additional jobs per month. That pace, Morgan Stanley says, would be sufficient to keep the unemployment rate roughly steady.
At the same time, Gapen cautioned that the Fed's tolerance for in-place policy is conditional. He warned that "if the unemployment rate falls below 4.0%, the Fed may see risks of an overheating labor market as justifying rate hikes." He added that his outlook would also change if monthly core inflation were to remain at 0.3% month-over-month or higher, or if the conflict in the Middle East resumes: "If monthly rates of core inflation remain at 0.3% month-over-month or higher, or if the conflict in the Middle East resumes, then our thinking could change," Gapen wrote.
Separately, Morgan Stanley suggested that the Fed's own inflation projections could be biased upward because those forecasts were likely formulated before the sharp fall in oil prices that followed the U.S.-Iran agreement. The bank noted this timing could mean that some FOMC participants' rate-hike projections - nine participants were identified in the note - are based on assumptions that no longer fully reflect current energy market developments.
Overall, the bank retains a cautious no-hike stance for now while setting out specific labour market and inflation thresholds that would prompt a reassessment.
Summary
Morgan Stanley maintains a baseline view that the Fed will keep rates unchanged through year-end, but will reconsider if unemployment drops below 4.0% or if core inflation remains elevated.
Key points
- The bank expects fourth-quarter headline and core PCE inflation of 3.2% and 3.0%, respectively, which it calls "substantially below the median FOMC participant."
- Projected payroll gains of 50,000 to 60,000 per month should keep unemployment roughly steady over the summer.
- Morgan Stanley flagged two clear triggers for a shift to rate hikes: unemployment falling below 4.0% and sustained monthly core inflation at or above 0.3% month-over-month; renewed conflict in the Middle East is an additional conditional factor.
Risks and uncertainties
- Labour market: A drop in the unemployment rate to below 4.0% could lead the Fed to view the market as overheating and justify raising rates - an outcome that would directly affect banks, lenders, and interest-rate-sensitive sectors.
- Inflation persistence: If monthly core inflation readings remain at 0.3% month-over-month or higher, monetary policy expectations could shift, with implications for fixed-income markets, insurers, and asset-liability management strategies.
- Geopolitical risk: A resumption of conflict in the Middle East could reverse recent oil price declines and alter inflation trajectories, creating uncertainty for energy markets and sectors exposed to input-cost volatility.