U.S. inflation reports this week showed a moderation in price pressures on an annual basis, prompting traders to pare expectations of Federal Reserve rate hikes. Morgan Stanley said the data confirmed its outlook of disinflation, but also noted that upside inflation risks remained which could affect its interest rate projections for 2027.
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According to the U.S. Bureau of Labor Statistics, headline U.S. consumer price index (CPI) growth slowed to 3.4% in July from 3.5% in June, while core CPI growth moderated to 2.5% from 2.6%. The corresponding measures for the producer price index (PPI) also moderated in July.
The inflation updates came after an unexpectedly weak July nonfarm payrolls report, and the indicators together suggest some breathing room for the Fed to keep interest rates on hold and wait for more data. Investors reacted accordingly by paring Fed rate hike bets for September. As per the CME FedWatch tool, the odds of the central bank holding steady next month currently stand at around 67%, compared to about 55% a week ago.
“Disinflation appears driven by tariff-payback, energy-price relief (and limited second-round effects), and moderating shelter inflation,” Morgan Stanley analysts led by Michael Gapen said on Friday.
“Fed patience remains the base case: Softer inflation alongside cooling employment and wage growth should allow the Fed to stay on hold through year-end,” they added.
While the CPI and PPI are widely used inflation indicators, the Fed prefers to track the core personal consumption expenditures (PCE) price index for which it has a longer-term target of 2%. Components from the CPI and PPI feed into the PCE.
“After incorporating July PPI data, we now project July core PCE inflation at 0.23% and headline at 0.14%, for annual changes of 3.27% and 3.64%, respectively,” the analysts said.
“If inflation follows our baseline outlook, with core PCE inflation slipping to 3.0% Y/Y in December and 2.4% at the end of 2027, then we forecast the Fed to stay on hold this year and reduce its policy rate by 50bp next year (with 25-bp cuts in March and June),” they added.
They also highlighted that risks to their monetary policy outlook skewed to the upside. Their forecast assumes a full recovery from recent supply side shocks without the emergence of a new shock. It also assumes limited price pressures related to artificial intelligence demand.
“One or both of these assumptions could be wrong,” Morgan Stanley said.
“Perhaps inflation diminishes into 2027, but not enough to warrant cuts next year. The Fed stays on hold through the end of our forecast horizon in this case. Alternatively, perhaps recent disinflation is a blip and inflation does not diminish further or even firms, prompting 50-75bp of rate hikes to reverse last year’s risk management rate cuts,” the brokerage said.
“Overall, we think the data points toward Fed patience. Disinflation is here. The question is how long will it last and how far will it go. We remain optimistic on this front and expect to see further progress toward the 2% target in the months ahead,” the analysts added.
Source: Investing.com
