Morgan Stanley has pushed back its forecast for the timing of the Federal Reserve's first interest rate cut, moving the expected dates from January and April to June and September. The bank contends that the core rationale for easing monetary policy has shifted from the labor market to inflation.
In its Global Macro Forum report released on January 12, the firm indicated that due to recent improvements in economic momentum and a declining unemployment rate, the urgency for the Fed to stabilize the job market has diminished. Future policy actions will depend on two key signals: the full price impact of tariff adjustments by the Trump administration and whether inflation data shows a clear downward trend.
The report argues that interest rate markets need to reprice overly optimistic expectations for rate cuts. While current market pricing is close to the bank's baseline forecast, it insufficiently accounts for tail risks such as persistent inflation. Morgan Stanley maintains its prediction for the Fed's ultimate target policy rate range of 3.0%-3.25%.
The report highlights that, given recent economic improvements and falling unemployment—coupled with a re-acceleration in the labor force participation rate of foreign-born workers—the pressing need for the Fed to implement emergency rate cuts to stabilize the labor market has significantly decreased. The policy focus has now pivoted to inflation, with the specific path being: first, await the full price transmission effects of tariff hikes, and then, crucially, confirm that inflation demonstrates a clear and sustainable trend back toward the 2% target before initiating a cutting cycle.
Morgan Stanley anticipates that this process of inflation moderation will begin in the second quarter of 2026, leading to the adjustment of the first rate cut forecast from January and April to June and September, with each cut remaining at 25 basis points.
Overall, the report does not alter the directional view that policy will eventually turn accommodative. For markets, this implies that the trading logic based on a "rapid policy pivot" at the start of the year needs recalibration, with the core driver of asset pricing returning to the evolution of inflation data itself. Against a backdrop of a resilient labor market and inflation not yet fully under control, the Fed is expected to exhibit greater policy patience.
Current market pricing for the terminal policy rate (approximately 3.11%) is highly aligned with the probability-weighted path (3.22%) derived from scenario analysis by Morgan Stanley economists. However, the bank believes there is still room for downward adjustment in market expectations for the rate floor.
The current market pricing structure reflects investors' probability assignments for various macroeconomic scenarios: a 70% weighting for the baseline scenario, 5% for stronger demand, 18% for higher productivity, and only 7% for a mild recession. This distribution indicates that the market is clearly under-pricing "tail risks" such as an economic slowdown or recession. Morgan Stanley believes the future pricing focus should tilt towards a more dovish path.
From a term premium perspective, the difference between the 10-year Treasury yield and the market-implied policy rate floor widened after the "Liberation Day" of April 2, 2025. As of the report's release, model-indicated term premium stood at 19.0 basis points, at the lower end of the post-event volatility range. The bank expects term premium to maintain a range-bound pattern until key political events, such as the renegotiation of the USMCA, are resolved.
In summary, Morgan Stanley judges that while current market pricing is largely consistent with its baseline forecast, coverage of downside risks remains insufficient. Over time, if economic or inflation data surprises to the downside, further downward adjustments in the pricing of the policy rate floor are possible, but this adjustment is more likely to occur after mid-2026 rather than in the immediate short term.
Comments