The impending change in Federal Reserve leadership is unlikely to alter the course of monetary policy in the near term.
Morgan Stanley's Chief Economist, Seth Carpenter, recently stated that despite the approaching end of Powell's term as Chair and the nomination of Warsh as a potential successor, the Fed's policy reaction function will not undergo a substantive shift. Last week's FOMC meeting maintained the status quo on policy, with two dissenting votes favoring a rate cut highlighting the internal divisions within the committee.
Although Warsh has publicly expressed that the Fed's balance sheet should be reduced, any such change would require building support and consensus within the FOMC, pushing any related decisions into next year. Morgan Stanley maintains its base case expectation of two interest rate cuts in the second half of this year, contingent upon tariff-driven inflation subsiding and a clear re-emergence of the disinflationary trend.
The bank believes the Fed's currently large balance sheet is a decision of the existing FOMC; even if a new Chair desires reduction, it would take time to secure consensus. Market pricing is currently aligned with this base case expectation. However, if the unemployment rate declines further, spending remains robust, and inflation fails to decelerate, the Fed could potentially hold rates steady for the remainder of the year.
The FOMC's voting mechanism inherently limits abrupt policy reversals.
On one hand, monetary policy decisions are made by FOMC vote, not by the Chair alone. Last week's dissenting votes clearly illustrated this point. While the Chair traditionally holds authority to lead the FOMC, any attempt to significantly deviate policy from the committee's standard reaction function would likely face multiple dissenting votes. Morgan Stanley judges that any policy shift would likely deviate by at most around 25 basis points from the FOMC's current framework.
On the other hand, none of the candidates previously listed by the White House hold particularly divergent views on monetary policy from the mainstream, as evidenced by their public statements. Furthermore, the Powell-led Fed's reaction function during this unusual economic period has not been static itself; in the second half of last year, the policy focus shifted from concern over excessively high inflation to "insurance cuts" based on weak employment growth.
The productivity narrative could emerge as a critical variable.
Interpreting the economic implications of low unemployment, high inflation, and strong growth requires a clear judgment on productivity. Powell, in a recent press conference, indicated the FOMC sees some cyclical improvement in productivity but has not attributed it to artificial intelligence. Productivity will be a key argument for persuading the FOMC to cut rates amidst robust economic growth. Former Chairman Alan Greenspan successfully used this argument in the mid-to-late 1990s to justify holding rates steady despite accelerating growth and falling unemployment.
However, inflation remains elevated, and the overall tone from last week's Fed meeting communicated a view of solid economic activity. Against a backdrop of five consecutive years of inflation above target and a labor market that may be starting to improve, the base case for further rate cuts is not a certainty. Morgan Stanley's constructive growth outlook, particularly for the second half, presents a certain contradiction with additional easing, but the bank assumes that disinflation will ultimately prevail.
Should the unemployment rate fall further, business and consumer spending maintain their current strength, and inflation fail to decelerate after this quarter, even a Powell-led Fed would certainly question the value of further accommodation. Such a data combination would raise questions about the level of the neutral rate and whether it has already been reached. Regardless of any leadership change, strong spending coupled with persistent inflation and low unemployment could lead the FOMC to remain on hold for the rest of the year.
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