One Fed Hike—Or More to Come?

0:00Michael Gapen:Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy at Morgan Stanley. And I'm Michael Gapen, Morgan Stanley's Chief U.S. Economist. Today, what the Federal Reserve decided at its September meeting and what it could mean for rates through the end of the year. It's Wednesday, September 16th at 4 p.m. in New York. So, Mike, the Fed raised rates by 25 basis points at this week's meeting. What stood out to you the most in the decision? And when it comes to inflation, how do you think this 25 basis point rate hike is actually going to affect the inflation outlook?

0:40Matthew Hornbach:Yeah, so certainly the decision was in line with expectations. You know, obviously what we've learned in the very broad sense is that inflation isn't moving fast enough in the direction that the Fed wants. So it's responding by tighter monetary policy. And that does set up a very interesting question, which you just asked, which is, well, is it going to work? Is this the right response to the inflation that we're seeing? So if you do go back and reread that Jackson Hole speech, there's not a lot in there about the drivers of inflation, what's causing higher inflation. But it's clear the only response to above target inflation from the point of view of the chair was tighter monetary policy.

1:22Matthew Hornbach:So the Fed is in a bit of a pickle. Most of us believe the majority of the inflation we're seeing is supply-side driven from tariffs, from energy, at least in the past. Let's call it supply chain disruptions, a deglobalization narrative. Some of it is demand-side driven through AI. But I think we're all looking at that thinking modestly tighter rates isn't necessarily going to bring down that AI-related inflation. So we're left to conclude that the Fed's in this uncomfortable position of saying, well, a lot of the inflation that we're seeing is supply-side driven and from the structural AI story that we're not convinced higher rates can maybe address.

2:05Matthew Hornbach:So I think the answer would be if inflation is going to come down, then higher rates will be weighing on the parts of the economy that are more interest rate sensitive and generally soft already.

2:18Michael Gapen:Is this a one and done? Or do you think that when the Fed actually goes ahead and hikes rates after a long pause, they are thinking about delivering more than just one rate hike?

2:31Matthew Hornbach:I strongly believe the committee as a whole is thinking in terms of more than one move. Monetary policy doesn't, say, hyperreact. It reacts with a bit of a delay. So to your point, they've been on hold for a while. When they think about changing policy, then they're thinking about a series of moves. So I think in their mind, if they're raising rates, there's a strong probability that they will do at least one more or two more. They're never going to think that a 25 basis point move in the funds rate will fundamentally change the macro outlook. So I don't think they'd ever walk into this thinking one and done.

3:12Matthew Hornbach:Now, it is possible we get an ex post one and done. So how could that come about? If it is true indeed that we're right that a lot of this inflation is supply side driven, it is coming down. It's clear that the three and six month annualized rates are pointing to disinflation into year end. We can debate whether it's fast enough or not. But if disinflation continues to happen, then the Fed will have hiked, expect to maybe do another one. But by the time we get there, inflation has improved enough and they end up not doing it. So they would sound like, oh, we're still ready. We still think we've got more work to do.

3:50Matthew Hornbach:But in the moment, the data just arrives in a way that they stay where they are. So you would look back and say it was a one and done. But I don't think they go in to this thinking one rate hike is going to fundamentally change the story.

4:02Michael Gapen:Now, of course, the data that we'll get between today and the December meeting will likely have an impact on their decision making, as well as any revisions that we end up getting. And I think one of the stories that investors have been talking about are some of the methodological changes that the Bureau of Economic Analysis is implementing into the PCE inflation data. Do you see any scope for those types of revisions to lend itself to a one and done type of a policy for this year?

4:39Matthew Hornbach:It's possible. There's uncertainty about what actually those revisions are going to bring. But quality adjustments to software, for example, will over time likely bring inflation lower, some of the revisions to the other categories. So we do think it will, on average, lower year-on-year rate of inflation by about a tenth or so, maybe a little more. So it could show up on the high side. And then you've got what looks to be a different path. So yes, I think one of the reasons to maybe go slower, think about perhaps a quarterly pace of hikes, as opposed to, oh, we're just going to ramp up three, four meetings in a row, is to let some of this play out, see what those revisions look like.

5:22Matthew Hornbach:So yes, it could contribute to a world where revisions plus softness in the incoming data mean they hike, say, in September, don't do another one after that. Or those revisions are part of the reason why they think a slower moving cycle rather than a more aggressive one is appropriate.

5:40Michael Gapen:Does the labor market play any role today in monetary policy?

5:45Matthew Hornbach:I think it's certainly secondary, if not tertiary. I don't want to say that the committee as a whole sees the labor market just fine and we don't have any concerns there. What's super helpful from the rate hike perspective is labor income, wage income out of the labor market is still decelerating and pretty modest. It doesn't suggest that the economy is overheating and the labor market is a source of upward pressure on inflation. So I think that's beneficial in terms of thinking of the rate hike cycle. In the other direction, I'd say we've had a number of months now of kind of, you know, let's call it 50 to 70 ,000 jobs a month on average if you kind of smooth through some of the volatility.

6:28Matthew Hornbach:That's not amazing, but it's not awful either. So, Matt, I'd like to turn it back to you. This is, of course, the economist perspective when we translate this into the rates market. Rates market clients may have a very different view, but I would be interested to hear your thoughts on how you think the rates market is dealing with the inflation. I don't want to say impulse, but let's call it the sticky disinflation we're getting, the sources of that inflation, and how it sees monetary policy reacting. How's the rates market digesting all of this?

7:02Michael Gapen:So I think actually investors are reasonably nonplussed about what's happening in the underlying rate of inflation in the country. But what has inserted itself into the conversation is the price of energy and how impulsively energy prices have risen over recent months. When we look at how market prices evolve with respect to the path for monetary policy, what we observe empirically is that if energy prices are going up in a given week or in a given month, the market reprices to a more hawkish path for Fed policy. And if energy prices come down in a given week or a given month and we see the market pricing towards a less hawkish path for monetary policy.

7:57Michael Gapen:So the primary driver of how the markets are pricing the future of Fed policy is in fact the changes in the price of energy commodities. So Brent crude oil, WTI crude oil, gasoline prices. And so this is something that we just can't get away from. There are, of course, other things that do influence the level of treasury yields, but I would suggest that they are more secondary or tertiary themselves in terms of similar to the labor market. I would say they have less of an impact on the overall level of yields. So with a market implied hiking cycle from the Fed at about three hikes or so from here, given that the Fed just delivered one rate hike, the 10-year treasury yield is around 5%.

8:54Michael Gapen:It was much lower earlier this year, and we were pricing in two rate cuts at that point in time. So you get the sense that if the market's moving from pricing in two rate cuts to pricing in four rate hikes, and the 10-year yield goes from 4.25 % to 5%, obviously there's a relationship there. One factor that investors are certainly interested in is how does the debt stock play a role in the level of yields? And one of the things that I've been telling people to consider is that it's not the level of the debt, the amount of debt in the economy that matters most for the level of interest rates, as odd as that may be to hear for listeners.

9:41Michael Gapen:it's how quickly that debt stock grows. So if the debt stock is going up at a certain pace and that pace is within the bounds of investor expectations then it typically doesn't have that big of an impact on the bond market. So one of the factoids that may surprise people is about four years ago the news media was very interested in the fact that the amount of debt in the United States had breached$31 trillion. And the 10-year treasury yield at that time had peaked at about 4.25%, somewhere around there. Well, earlier this year, before the conflict in Iran began, the 10-year treasury yield was also around 4.25%.

10:24Michael Gapen:But this is four years later. And over these four years, the U.S. has added$9 trillion to the debt. So here again, this is a good example, I think, of this idea that you can have a dramatic expansion in the debt from$31 trillion to$40 trillion. And yet the 10-year treasury yield itself is broadly unchanged. And so that just, I think, should tell investors that it's not the size of the debt that matters per se. Lots of other factors can influence the level of treasury yields and how the market thinks about the Fed is certainly among the more important of those. So, Mike, I just want to say thanks again for taking the time to talk after another FOMC meeting.

11:11Michael Gapen:Great speaking with you, Matt. And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.

11:24Michael Gapen:The preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for you.