Geopolitical tensions linked to Iran and the resulting swings in oil prices have altered market expectations for the path of U.S. interest rates, according to analysis from Morgan Stanley. The firm argues that the probability distribution for Federal Reserve policy has become skewed - with greater odds that rate reductions will come later than currently forecast, or that they will be both delayed and larger in total.
Morgan Stanley's chief U.S. economist, Michael Gapen, summarizes the firm's view succinctly:
"The distribution of monetary policy outcomes is asymmetric."
Gapen adds that the Fed is "more likely to cut later, or to cut later and by more, rather than abandon its easing altogether." That framing underpins Morgan Stanley's central expectation for 2026: two rate cuts, scheduled for June and September, on the assumption that policymakers will look through any temporary upward pressure on prices caused by oil.
But the firm explicitly flags two risks that could alter that timeline. The first risk is that elevated inflation together with still-low unemployment could persuade the Fed to postpone action. With inflation already at 3.0% and having firmed, rising oil prices could push inflation further from the central bank's target. If policymakers adopt a more patient stance, Morgan Stanley notes cuts might shift later in the year - for example to September and December - or into December and the following March. In this delayed scenario, the firm anticipates the eventual terminal policy range would still sit between 3.0% and 3.25%.
The second risk outlined by Morgan Stanley carries a different consequence. If the Fed waits too long before easing, the combination of higher-for-longer oil prices and increased uncertainty could reduce demand more than the firm currently expects. Under that outcome, tighter financial conditions would weigh more heavily on economic activity, prompting the Fed to conduct a larger easing cycle. Morgan Stanley says this path could produce three cuts and lower the terminal rate to a range of 2.75% to 3.0%.
For now, Morgan Stanley maintains its baseline forecast of two cuts in 2026, but the firm emphasizes that the risks are skewed toward later cuts or later cuts to a lower trough.
Key points
- Geopolitical developments involving Iran and volatile oil prices have increased the likelihood of delayed Federal Reserve easing.
- Morgan Stanley's base case calls for two cuts in 2026, in June and September, assuming oil-driven price pressures are temporary.
- The main sectors implied to be affected include the energy sector and interest-rate-sensitive assets such as fixed income and sectors exposed to borrowing costs.
Risks and uncertainties
- Higher inflation and still-low unemployment could push policymakers to postpone cuts - a scenario that would affect bond markets and borrowing-sensitive sectors.
- If higher-for-longer oil prices and increased uncertainty do more damage to demand than expected, the Fed could deliver three cuts and a lower terminal rate, amplifying pressure on cyclically exposed sectors.