Kevin Warsh’s inaugural meeting as chair of the Federal Reserve has, in Morgan Stanley’s assessment, represented a meaningful step toward repairing the central bank’s standing with markets. The investment bank welcomed the tone and policy signals from the meeting, while flagging a separate, more pressing worry for stocks - deteriorating liquidity conditions.
Market moves in the immediate aftermath of the meeting - selling pressure across both equities and bonds, a bear-flattening of the yield curve, a firmer dollar and weaker gold prices - were interpreted by Morgan Stanley as evidence that investors are treating the new leadership as credible and willing to steer policy with renewed emphasis on inflation control.
Michael Wilson, Morgan Stanley’s equity strategist who supported Warsh’s nomination in February, pointed to the near 40% rise in the S&P 500/Gold ratio since Warsh’s nomination as an indicator that markets have afforded the new chair the benefit of the doubt. The bank’s strategists concluded from these signals that markets expect the Fed under Warsh to shake up its toolkit, reduce dependence on the balance sheet as an active policy instrument and help restore confidence in policy makers.
Key policy actions at the FOMC meeting underlined that inflation is being treated as the central objective of the Fed, rather than growth or labor-market targets. Warsh emphasized the Fed’s失ure of missing its inflation goal for five consecutive years, and his approach included removing the traditional dot plot and moving away from heavy forward guidance.
Morgan Stanley’s analysts welcomed the shift away from extended guidance. They argued that lengthy forward guidance had distorted market signals and made investors overly focused on anticipating Fed actions instead of responding to incoming economic data.
The new chair also signaled comfort with inflation carrying a "2 handle" - a phrase that Morgan Stanley read as indicating a tolerance for inflation anywhere from 2.0% up to 2.9% rather than an insistence on a strict 2.0% ceiling. The bank viewed this as an implicit acknowledgment that policymakers may accept moderately higher inflation over time in order to manage broader economic trade-offs.
Despite the favorable view of Warsh’s early management of the Fed, Morgan Stanley’s primary short-term concern for equities centers on liquidity, not on the prospect of further rate increases. The bank highlighted three specific developments that have reduced market liquidity: the Fed’s Reserve Management Program has been scaled back from $40 billion per month to $10 billion; Treasury buybacks have shrunk by roughly 50%; and lending growth is accelerating.
"Liquidity remains the greater risk to equity markets in the short-term rather than any fears about the Fed raising rates to fight inflation," Morgan Stanley’s team wrote, noting that the firm’s proprietary liquidity indicators point to headwinds extending into July.
At the same time, the bank continued to place the primary engine of the bull market on corporate earnings. Morgan Stanley remains of the view that earnings are likely to top full-year expectations, which should help offset the multiple compression that equities have experienced year-to-date.
On the macroeconomic outlook, Morgan Stanley’s economists judged the market’s early reaction to the FOMC meeting as somewhat exaggerated. Their baseline remains that the Fed will keep policy on hold through the year. The firm’s own forecast for core personal consumption expenditures inflation stands at 3.0%, below the Fed’s projection of 3.3%.
Morgan Stanley’s economists also highlighted factors they expect to ease inflationary pressures: fading tariff-driven price effects and significantly lower oil prices, which they say make sizable second-round inflation impacts unlikely. They noted that a median FOMC participant who had priced in a rate hike this year followed by a cut next year would need to revise that view should inflation prove noticeably more subdued than current expectations.
Summary
Morgan Stanley sees Kevin Warsh’s first FOMC meeting as a credibility-building moment for the Federal Reserve, reflecting a renewed focus on inflation and less reliance on balance-sheet tools. Yet the firm warns that reduced market liquidity - stemming from smaller Fed reserve management purchases, halved Treasury buybacks and rising lending - is a more immediate threat to equities than additional rate hikes. The bank expects earnings to remain the primary driver of the market and projects near-term liquidity headwinds to persist into July.
Key points
- Warsh’s first FOMC meeting bolstered Fed credibility by prioritizing inflation and signaling less dependence on balance-sheet policy tools.
- Liquidity deterioration - including a cut in the Fed’s Reserve Management Program from $40 billion to $10 billion per month and about a 50% reduction in Treasury buybacks - is viewed as the near-term equity risk.
- Morgan Stanley expects corporate earnings to remain the main support for the bull market and forecasts core PCE at 3.0%, below the Fed’s 3.3% projection.
Risks and uncertainties
- Persisting liquidity headwinds into July could exert pressure on equity valuations, especially for risk-sensitive sectors.
- If inflation dynamics change unexpectedly, the Fed’s stance and the market’s pricing of future policy could be forced to adjust, creating volatility across fixed income and equity markets.
- Reduced Treasury buybacks and smaller central bank reserve management purchases may limit market depth, amplifying moves in rates and equity prices.