Despite the bond market’s increasing expectations that the Federal Reserve will soon need to hike short-term interest rates, one major bank says the central bank will maintain holding rates steady and then resume a dovish stance next year.
Morgan Stanley’s May 18 note, shared with TheStreet, calls for two 25-basis-point rate cuts in 2027, one in March and the other in June.
“The bar for monetary easing has risen, and we expect the Fed to remain on hold through 2026 before beginning a gradual normalization cycle in 2027,’’ the note said.
The note said that despite back-to-back hot inflation reports last week and multiple forecasts that the Iran War energy shock will continue to spike prices this summer, those increases will be temporary, much like the fading impact of tariffs on prices.
“Key assumptions underpinning our core inflation outlook are that tariff passthrough will fade over the coming months and that oil spillovers into core (inflation) will remain limited,’’ the note said.
Fed has kept interest rates steady
The Federal Open Market Committee continued to hold the benchmark Federal Funds Rate — which impacts the cost of short-term borrowing — steady at 3.50% – 3.75% during its April 30 meeting.
But the divisive 8-4 vote among its 12 members reflected the concerns of three regional Fed presidents that rising inflation and stabilizing labor data indicated the Fed should consider tightening policy in its post-meeting statement.
The policymakers cut rates by 25 basis points at their last three meetings of 2025 to shore up the softening labor market.
The next FOMC meeting is June 16-17 and will be the first with Kevin Warsh as Chair.
President Donald Trump and other White House officials repeatedly called for the central bank to slash rates dramatically, to 1% or lower.
Warsh, who will be sworn in on May 22 in a White House ceremony, has said the Fed needs to lower interest rates and shrink its $6.7 billion balance sheet as part of a “regime change” he pledged during his Senate confirmation hearings.
Bond market ups Fed rate-hike forecast
Bond traders have been preparing for higher inflation risks since the Iran War began in late February.
And that preparation includes the possibility that the central bank will need to raise interest rates sooner than anyone expected, especially Warsh.
The CME Group FedWatch Tool raised the probability of a 25-basis-point rate hike this year to 50% to 60%, up from 40% odds last week.
The 30-year Treasury yieldtopped the 5% threshold last week, and the benchmark 10-year yield hit the 4.5% mark for the first time since June 2025. The two-year yield rose above 4% for the first time in 11 months.
Veteran analyst Ed Yardeni said in a May 18 note that the Fed could hike interest rates as soon as July 2026, reshaping the 2026 rate-bet outlooks.
Were the FOMC to decide on raising rates,BNP Paribas said last week, it would most likely begin to do so at its December 2026 meeting.
Inflation rises, jobs stabilize in latest reports
Economists are broadly forecasting that the April Personal Consumption Expenditures inflation report — the Fed’s preferred inflation gauge due May 28 — will remain elevated and reinforce expectations that the central bank keeps the benchmark Federal Funds Rate higher for longer.
The Bureau of Economic Analysis released the March PCE on April 30, showing an acceleration in headline inflation largely driven by energy costs.
- Headline PCE (Year-over-Year): 3.5% up from 2.8% in February.
- Core PCE (Year-over-Year): 3.2% (excluding food and energy) up from 2.9% in February.
The Bureau of Labor Statistics on May 13 said the April Producer Price Index jumped 6%, the biggest year-over-year increase since 2022.
Related: BofA drops blunt warning about Fed rate cuts
The April Consumer Price Index also came in hot on May 13, jumping to 3.8% on a year-on-year basis, outstripping workers’ earnings for the first time in three years and marking the highest inflation print since the post-pandemic recovery in May 2023.
- The headline CPI climbed 0.6% from March, while the core gauge excluding food and energy costs rose 0.4%.
- Energy prices soared 17.9% year-over-year, with gas prices up 28.4% and fuel oil prices up a whopping 54.3%.
The Fed’s own 2% inflation target has not been met in five years, largely due to the lingering pandemic and the effects of tariffs and energy shocks.
Despite the rising energy costs fueled by the Iran War, U.S. employers added more jobs than expected for a second month in April, and the unemployment rate held steady at 4.3%, the Bureau of Labor Statistics reported.
Fed’s mandate requires a tricky balance
The Fed’s dual mandate from Congress requires maximum employment and stable prices.
- Lower interest rates support hiring but can fuel inflation. This risks fueling further inflation, potentially leading to an inflationary spiral.
- Higher rates cool prices but can weaken the job market. This increases the cost of borrowing and further stifles economic activity.
Morgan Stanley outlines inflation, rate outlook
The Morgan Stanley note said the deceleration in core inflation is partly based on the view that “we will get somewhat slower consumption growth” this year, which will limit pressures from the demand side of the economy.
“In the coming quarters, we expect the oil shock to weigh on consumer purchasing power,” especially for the low- and middle-income cohorts, the note said.
“This leads to continued slow growth in goods spending in the near-term, but high-income consumers should be able to smooth through the shock, limiting downside risk,’’ the note said.
Morgan Stanley recently published its U.S. Economics Mid-Year Outlook, updating its forecasts for the remainder of the year.
“Our baseline view included 2Q GDP at 2.3%, with personal consumption at 1.7%,’’ the note said. “With April retail sales stronger than expected, we revise up both 2Q consumption and GDP by a tenth.”
Related: ‘Unhinged’ bond yields reset Fed rate-cut odds