Morgan Stanley told clients that the balance of risk around the Federal Reserve's interest-rate trajectory is skewed toward easing occurring later than markets expect - and potentially involving deeper cuts. The bank flagged ongoing uncertainty in inflation dynamics as the principal reason for that tilt.
Near-term inflation pressure
The firm highlighted that core PCE inflation - the Fed's preferred inflation measure - will likely register strong prints in the first quarter. Morgan Stanley expects the three-month annualized pace of core PCE to move above 4% in February, a reading that could complicate the Fed's decision calculus in the near term.
Why Morgan Stanley still views recent strength as temporary
Despite predicting a firm near-term profile for core inflation, Morgan Stanley indicated it views much of that strength as transitory. The bank said core inflation should start to decelerate from the second quarter as several temporary contributors fade.
Among the factors cited are tariff-related price increases and seasonal distortions that tend to push inflation readings higher early in the year. The bank noted that tariffs have elevated goods prices as companies passed through added costs during annual price resets, but it expects most of that effect to dissipate over time.
At the same time, Morgan Stanley pointed to signs of moderation in shelter inflation - a significant component of services prices - which could help reduce broader inflation pressures as the year progresses.
Energy and inflation expectations
The bank argued that oil price shocks by themselves are unlikely to materially boost core inflation unless they trigger a sustained rise in inflation expectations. In other words, temporary spikes in energy costs would not automatically translate into persistent higher core inflation unless they change the public's longer-term outlook on inflation.
Policy implications
Given its inflation outlook, Morgan Stanley expects the Federal Reserve to implement two rate cuts this year. However, the bank cautioned that policymakers may delay the start of easing until there is clearer evidence that inflation is trending down.
Conversely, the bank said that tighter financial conditions and the potential for consumer strain from higher energy prices could strengthen the argument for additional easing if economic growth weakens. That contingency leaves room for a range of policy outcomes depending on how inflation, financial markets, and consumer pressures evolve.
Key takeaways
- Morgan Stanley views risks as skewed toward later and possibly larger Fed rate cuts.
- Core PCE likely to show strong readings in Q1, with a three-month annualized pace expected above 4% in February.
- The bank expects core inflation to begin cooling from Q2 as tariff pass-throughs and seasonal effects fade, and as shelter inflation shows signs of slowing.
Sectors likely affected
- Consumers - through goods prices and potential pressure from energy costs.
- Housing and services - via shelter inflation trends.
- Financial markets - through changes in interest-rate expectations and tighter financial conditions.