Morgan Stanley still expects 25bp rate cut in September

Morgan Stanley reiterated its expectations that the Federal Reserve will cut rates by 25 basis points (bp) at the September meeting.

After two weeks of stronger-than-expected data, the market is pricing in a 25% probability of a 50 basis point rate cut in September, according to the bank. It expects investors to continue debating the likelihood of 25bp versus 50bp cuts leading up to and following the Jackson Hole Economic Symposium, especially following Chair Powell’s opening remarks.

The annual symposium, set to be held from August 22 to 24, is likely to delve deeply into differing perspectives on policy lags and the economy’s sensitivity to interest rates.

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

“Our economists continue to project a 25bp rate cut in September."

The bank believes that most FOMC participants are likely to agree with this projection, considering the recent economic data. Its economists are forecasting a 0.16% month-over-month increase in July’s core PCE inflation, which would annualize at 1.9%. Such a figure “would make early 2024 inflation look more like outliers,” the note states.

Morgan Stanley’s team believes that investors see the decision between a 25bp and 50bp rate cut as dependent on upcoming labor market data. Nonetheless, they argue that FOMC participants might avoid starting the easing cycle with a 50bp cut.

This is because such a move would contradict the recent SEP dot-plot projections, could attract public criticism for delayed action, and might alarm investors by signaling a possible recession, as larger rate cuts have historically occurred during economic downturns.

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

Such concerns have notably influenced rates markets, as seen in 2001 and 2007, when the Fed opened easing cycles with 50bp cuts. In those instances, fed funds futures rallied sharply, with implied rates dropping over 80bp in 2001 and 60bp in 2007, the bank highlights.

Strategists see the potential for markets to price in a higher probability of a 50bp rate cut at the November meeting, especially given the substantial economic data to be released before then. They also note that FOMC participants may discuss 50bp moves in upcoming meetings, even if they don’t implement them immediately.

Source: Investing.com