Market Analysis

Morgan Stanley reaffirmed its expectation that the Federal Reserve will reduce rates by 25 basis points (bp) at the September meeting.

Despite two weeks of stronger-than-anticipated economic data, the market is currently assigning a 25% probability of a 50 basis point rate cut in September, according to the bank. Morgan Stanley anticipates that investors will continue to debate the likelihood of a 25bp versus 50bp cut leading up to and following the Jackson Hole Economic Symposium, especially in light of Chair Powell’s opening remarks.

The annual symposium, scheduled for August 22 to 24, is expected to offer a deep dive into various perspectives on policy lags and the economy’s sensitivity to interest rates.

"We would be surprised if Chair Powell preempts the debate about the size of the September rate cut during his opening remarks or any press interviews," Morgan Stanley strategists noted in a recent report.

“Our economists maintain their forecast for a 25bp rate cut in September.”

The bank suggests that most FOMC members will likely align with this forecast, given the recent economic data. Its economists predict a 0.16% month-over-month increase in July’s core PCE inflation, translating to an annualized rate of 1.9%. This figure “would make early 2024 inflation appear more like an outlier,” the note explains.

Morgan Stanley’s team believes that investors view the decision between a 25bp and 50bp rate cut as contingent on upcoming labor market data. Nevertheless, they argue that FOMC members may be reluctant to start the easing cycle with a 50bp cut.

Such a move, they suggest, would conflict with the recent SEP dot-plot projections, could attract public criticism for delayed action, and might unsettle investors by signaling a potential recession, as larger rate cuts have historically been associated with economic downturns.

“Investors may become concerned about a recession after a 50bp rate cut, simply due to the limited experience with Fed policy targeting an effective federal funds rate and recessions,” the strategists wrote. “The only easing cycle since 1990 that didn’t involve 50bp rate cuts also didn’t see the NBER declare a recession.”

These concerns have significantly influenced rates markets, as evidenced in 2001 and 2007, when the Fed initiated easing cycles with 50bp cuts. In those cases, fed funds futures surged, with implied rates dropping over 80bp in 2001 and 60bp in 2007, according to the bank.

Strategists suggest that markets might price in a higher likelihood of a 50bp rate cut at the November meeting, especially considering the substantial economic data expected before then. They also note that FOMC members may discuss 50bp cuts in upcoming meetings, even if they don’t implement them right away.

Paraphrasing text from "Reuters" all rights reserved by the original author.