[US Interest Rates] Morgan Stanley Lists Five Key Reasons, Expects the Fed to Hold Steady This Year; Says the Market Has Overestimated the Level of Inflation

The market is divided on the outlook for the Federal Reserve's monetary policy in the second half of the year. Although interest rate futures suggest the Fed will raise rates at least once this year, Morgan Stanley still expects the Fed to hold steady in 2026, keeping interest rates unchanged, and to cut rates twice in 2027 as inflation gradually normalizes.

Morgan Stanley lists five reasons why it believes the inflation outlook is more moderate than market and Fed forecasts, estimating that the PCE and core PCE for the fourth quarter will be 3.2% and 3%, respectively, lower than the median forecasts of FOMC members.

Morgan Stanley: The recent decline in oil prices should at least partially reverse the earlier inflation shock

• First, the pass-through pressure from tariffs on prices is nearing its end, and housing inflation is also slowing, which means core goods inflation will gradually normalize.

• Second, the recent decline in oil prices should at least partially reverse the earlier inflation shock. Easing geopolitical tensions and the subsequent drop in energy prices could have a positive impact on the transportation sector, especially airfares, thereby lowering inflation in the coming months.

• Third, the FOMC may be overestimating inflation. The June forecasts may have been made before the signing of a preliminary memorandum between the US and Iran, so the overall inflation forecast may not fully reflect the subsequent decline in energy prices.

• Fourth, the Fed's forecasts assume that monthly inflation rates will be similar to those from April to December 2025, a period when tariffs and high housing prices were pushing inflation forecasts higher. However, the bank estimates that, amid slowing goods and housing inflation and seasonal factors, core inflation in the second half of 2026 will rise by close to 0.2% or less on a monthly basis.

• Fifth, the macroeconomic backdrop supports the Fed's patience. Recent data shows that consumer spending is slowing, and the strong nonfarm payroll growth is unlikely to persist. Therefore, if economic activity slows as expected, it will further reduce the need to tighten monetary policy.

Morgan Stanley says that based on these five reasons, even if the Fed's recent tone has been hawkish, it is still possible that it will keep interest rates unchanged.