The Federal Reserve held interest rates steady during its April FOMC meeting, marking the final public appearance of current Chair Jerome Powell during his term. Following the meeting, Morgan Stanley comprehensively adjusted its forecasts, pushing back two previously anticipated 2026 rate cuts to early 2027. Sticky core inflation, surging oil prices, and internal divisions at the Fed were cited as the three primary drivers for this revision.
This week's meeting signaled a critical shift in the Fed's policy stance. Michael Gapen, Chief Economist at Morgan Stanley, noted that the committee is moving from an accommodative bias toward a neutral posture, with the bar for interest rate cuts now significantly higher. Despite ongoing economic resilience and a stable labor market, policymakers require clear evidence of declining inflation before considering easing. With policy nearing a neutral setting, the urgency for monetary loosening has diminished considerably.
The meeting was notable for revealing substantial internal disagreement: a member from the former Trump administration, Milan, supported a rate cut, while three hawkish members strongly advocated for removing accommodative language from the policy statement. The 8-4 vote outcome represented the most significant split since 1992, indicating a complete breakdown of policy consensus.
Market expectations shifted dramatically in response. According to CME FedWatch data, the probability of rates holding steady through 2026 rose to 83.6%, up significantly from 75.9% the prior week. The 2-year U.S. Treasury yield initially jumped to 3.96% following the decision before retreating by 4 basis points on Thursday, reflecting a market reassessment of the prospect of prolonged higher rates.
Ongoing tensions between the U.S. and Iran around the Strait of Hormuz pushed Brent crude to a four-year high on Thursday, directly increasing inflationary pressures. Morgan Stanley emphasized that the path for core inflation is "more persistent," with energy shocks stemming from the Middle East crisis undermining disinflationary trends.
While the firm still expects core inflation to moderate as tariff effects fade and housing inflation slows, it issued a clear warning: if oil prices remain elevated long-term, the pass-through from energy to core inflation could exceed expectations, potentially forcing the Fed to maintain high interest rates for an extended period. Recent data showed March core inflation rose 3.1% year-over-year, still well above the 2% target, indicating conditions for rate cuts are not yet in place.
Consequently, Morgan Stanley maintains that the Fed is more likely to delay rate cuts rather than cancel them entirely. Its baseline scenario now anticipates the Fed holding rates steady throughout 2026, followed by two 25-basis-point cuts in January and March of 2027.
In light of the revised interest rate outlook, Morgan Stanley advises investors to adjust their portfolios by increasing exposure to 5-year U.S. Treasuries and Treasury Inflation-Protected Securities (TIPS), while also betting on a widening yield spread between 7-year and 30-year government bonds.
Simultaneously, Morgan Stanley observed a new paradigm emerging in foreign exchange markets, where the euro-dollar exchange rate has decoupled from interest rate differentials and is currently driven by Middle East tensions and the U.S. dollar's safe-haven status.
The firm noted that rate differential logic is expected to reassert itself once geopolitical tensions ease. Should the U.S. and Iran reach an agreement, the euro could fall to 1.12 against the dollar. However, a stabilization in Gulf conditions coupled with sustained shifts in interest rate trajectories would subsequently benefit the euro. Markets are currently pricing in 83 basis points of rate hikes by the European Central Bank in 2026.
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