Morgan Stanley: Fed policy unlikely to shift in the short term; balance sheet reduction will have to wait at least until next year.

The change in the Federal Reserve leadership is unlikely to alter the direction of monetary policy in the short term.

Seth Carpenter, Chief Economist at Morgan Stanley, recently stated that although Powell’s term as Chairman is coming to an end and Walsh will be the nominated successor, the Fed’s policy response function will not see substantial changes. Last week’s FOMC meeting kept policies unchanged, and two dissenting votes supporting rate cuts highlighted divisions within the FOMC.

Although Walsh has publicly stated that the Fed’s balance sheet should be reduced, any change would require building support and consensus within the FOMC, which will delay related decisions until next year. Morgan Stanley maintains its baseline forecast of two rate cuts in the second half of this year, provided tariff-driven inflation subsides and the downward trend in inflation clearly reemerges.

The firm believes the current large Fed balance sheet is a decision of the existing FOMC. Even if the new Chair wants to shrink the balance sheet, consensus-building will take time. Market pricing is currently aligned with this baseline expectation, but if unemployment further declines, spending remains strong, and inflation fails to fall, the Fed may keep rates unchanged for the rest of the year.

FOMC Voting Mechanism Limits Policy Swings

On one hand, monetary policy is decided by FOMC voting, not by the Chair alone. Last week's dissenting votes made this clear. Although the Chair has traditionally led the FOMC, any attempt to significantly deviate policy from the standard FOMC response function will encounter multiple dissenting votes. Morgan Stanley judges that policy changes from the current FOMC framework will deviate by at most about 25 basis points.

On the other hand, none of the candidates previously listed by the White House deviate significantly from mainstream positions on monetary policy. This can be seen from their public statements. Under Powell’s leadership, the Fed’s response function during special economic times was not static; last year, policy focus shifted from high inflation to “insurance cuts” based on weakening job growth.

Productivity Narrative May Prove to be a Key Variable

To interpret the economic implications of low unemployment, high inflation, and strong growth, a clear judgment on productivity is needed. Powell

stated at a recent press conference that the FOMC believes cyclical productivity has increased, but did not attribute this to artificial intelligence. If one wants to persuade the FOMC to cut rates amid robust economic growth, productivity will be a key argument. Former Chairman Greenspan used this rationale in the mid-to-late 1990s to maintain rates, even as economic growth accelerated and unemployment fell.

However, inflation is still rising, and the overall tone of last week’s Fed meeting conveyed a judgment of robust economic activity. With inflation having exceeded the target for five consecutive years and signs that the labor market may be starting to recover, further rate cuts are not a done deal. Morgan Stanley’s constructive growth outlook—especially for the second half of the year—conflicts somewhat with additional rate cuts, but the firm assumes inflation will fall and take precedence.

If unemployment declines further, business and consumer spending remains strong, and inflation does not decrease after this quarter, even a Fed led by Powell will surely question the value of accommodative policy. This data mix will trigger questions about the neutral rate of interest and whether it has already been reached. Even if leadership changes, robust spending combined with persistent inflation and low unemployment could keep the FOMC on hold for the remainder of the year.

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