With a "75 basis point rate cut" as the dividing line, the Federal Reserve has split into "two major camps"; the key disagreement is crucial for the market.

With a "75 basis point rate cut" as the dividing line, the Federal Reserve has split into "two major camps"; the key disagreement is crucial for the market.

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The latest interest rate strategy report from Morgan Stanley reveals that there is a clear split within the Federal Reserve along the line of "whether to cut rates by 75 basis points in 2025," with two distinct camps forming.

The latest dot plot shows that among the 19 FOMC members, 10 believe that cutting rates by 75 basis points or more this year is the appropriate policy path. Meanwhile, the other 9 members think that the rate cut should be less than 75 basis points.

However, simply labeling this division as a "dovish vs. hawkish" battle may overlook deeper dynamics. According to windchasing trading desk news, Morgan Stanley pointed out in its report on the 19th that the fundamental divergence between these two camps lies in their different perceptions of the "neutral rate (r*)." Although both sides agree on returning the policy rate to the neutral level by 2026 or, at the latest, by mid-2027, there is no consensus on where "neutral" actually is.

More crucially, the report observes that U.S. labor force growth has stalled, which means potential economic growth (g*) will slow, in turn creating strong downward pressure on the neutral rate (r*).

Dot plot reveals two major camps: surface of the split

The latest dot plot from September 2025 clearly displays the split within the FOMC. This division has appeared before, as seen in the March and June 2025 dot plots.

Specifically, the two main camps are separated by whether rates will be cut by 75 basis points within the year:

Camp One: Consists of 10 participants who believe that cutting rates by 75 basis points or more in 2025 is the appropriate policy path.Camp Two: Consists of the remaining 9 participants who believe the rate cut should be less than 75 basis points within the year.

Simply labeling the former as "doves" and the latter as "hawks" may misread the signal. To understand the deeper meaning, one must examine their views on the neutral interest rate.

The core insight of the report is that this split is not a traditional hawks vs. doves dispute, but a divergence on a more fundamental issue: Where exactly is the level of the neutral rate (r)?

The report points out that although there are differing opinions on the rate cut path for 2025, both camps expect to complete the transition to the neutral rate by 2026 or mid-2027 at the latest. The key divergence is that one camp likely believes the neutral rate should remain relatively high, while the other sees it as lower. Since the neutral rate is a theoretical concept and difficult to estimate precisely, there is great disagreement about its exact level. This is what has driven the dispersion in the dot plot.

Sudden halt in labor force growth: the source of downward pressure on neutral rates

The report cites the classic Holston-Laubach-Williams (HLW) model to analyze the relationship between the neutral rate (r*) and potential growth rate (g*). Historically, the two have been highly correlated. Although there was a divergence after the financial crisis, the direction remained similar. Since 2023, however, the gap between the two has widened again, with potential growth (g*) showing unexpected resilience. The report believes the driving factor behind this is labor force growth driven by post-pandemic immigration.

But now, things are reversing. The report presents data showing dramatic changes in U.S. labor force growth:

Pre-pandemic (2012.12 - 2020.02): Compound annual growth rate (CAGR) was 0.77%.Pandemic period (2020.02 - 2021.11): CAGR was -0.59%.Post-pandemic to before Trump’s inauguration (2021.11 - 2025.01): CAGR soared to 1.52%, double the pre-pandemic figure.After Trump’s inauguration (2025.01 - 2025.08): CAGR plummeted to just 0.03%, nearly stagnant.

The sharp slowdown in labor force growth strongly suggests that the U.S. economy’s potential growth rate (g*) is about to decline. According to the HLW model, a drop in potential growth will eventually translate to a drop in the neutral rate (r*).

 

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The above content comes from Windchasing Trading Desk.

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