Morgan Stanley delays expectation for this year's first rate cut, says the Fed's focus has shifted from employment to inflation.

Morgan Stanley has postponed its expected timing for the U.S. Federal Reserve's first interest rate cut from the originally forecasted January and April to June and September. The firm believes that the core logic for rate cuts has shifted from the labor market to inflation.

According to Chase Wind Trading Desk, on January 12, Morgan Stanley stated in its Global Macro Forum report that, given the recent improvement in economic momentum and the decline in unemployment rates, the Fed's urgency to stabilize the job market has eased. Future policy actions will depend on two key signals: the full impact of tariff adjustments by the Trump administration on prices, and whether inflation data clearly show a downward trend.

The report argues that the interest rate market needs to reprice overly optimistic rate cut expectations. Although current market levels are close to their baseline forecasts, there is still insufficient pricing for tail risks such as sticky inflation. The firm maintains its forecast for the Fed’s final target rate range at 3.0%-3.25%.

Shift from “employment-driven” to “inflation-driven”

The report notes that, given recent improvements in economic momentum and falling unemployment rates (foreign-born labor force participation is also reaccelerating), the urgency for the Fed to use emergency rate cuts to stabilize the labor market has notably declined. Policy focus has now shifted to inflation. The specific path will be: first wait for the full pass-through effect of additional tariffs on prices, then confirm that inflation is showing a clear and sustainable trend of returning to the 2% target before initiating a rate cut cycle.

Morgan Stanley expects this process of inflation slowdown will begin in the second quarter of 2026, and as such, adjusts the expected timing of the first rate cut from January and April to June and September, with each cut still at 25 basis points.

Overall, the report does not alter the directional judgment that policy will eventually shift to easing. For the market, this means that the early-year logic based on “rapid policy shift” needs to be recalibrated, and the core driver of asset pricing will once again return to the evolution of inflation data. With the job market remaining resilient and inflation not yet fully under control, the Fed is expected to show greater policy patience.

Market pricing is very close to Morgan Stanley's baseline scenario, but still underestimates tail risks

Currently, the market’s pricing of the terminal policy rate (around 3.11%) is highly consistent with the probability-weighted path (3.22%) derived from Morgan Stanley economists’ scenario analysis. However, the firm believes the market’s expectation for the rate floor still has room to move lower.

The current market pricing structure reflects the following probability distribution for various macroeconomic scenarios: baseline scenario at 70%, demand upside at 5%, productivity upside at 18%, and mild recession at only 7%. This distribution shows that the market is clearly underpricing “tail risks” such as slower economic growth or recession. Morgan Stanley believes that future pricing should tilt toward a more dovish path.

Looking at term premiums, the spread between the 10-year U.S. Treasury yield and the market-implied policy rate floor widened after “Liberation Day” on April 2, 2025. As of the report’s release, their model shows a term premium of 19.0 basis points, at the low end of the post-event fluctuation range. The firm expects that term premiums will remain range-bound until key political events, such as the renegotiation of the USMCA, are settled.

In summary, Morgan Stanley judges that although current market pricing is basically in line with its baseline forecast, coverage of downside risks is still insufficient. As time goes on, if economic or inflation data show unexpected changes, market pricing for the policy rate floor may move even lower. However, this adjustment process is more likely to occur after mid-2026 than in the short term.

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The above content is from Chase Wind Trading Desk.

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