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Morgan Stanley Research expects the US Federal Reserve to keep interest rates unchanged through 2026 despite market expectations of at least one rate hike, arguing that moderating inflation and already-tight financial conditions reduce the need for further policy tightening.
In a report titled "Watch Out for a Fed Pause", the investment bank said markets may be overestimating the likelihood of additional rate hikes this year, while its economists expect inflation to continue easing. "We expect a lower inflation trajectory that keeps policy on hold this year, potentially followed by two rate cuts in 2027 as inflation gradually normalizes," said Michael Gapen, Chief US Economist for Morgan Stanley Research. Gapen added, "The main source of this divergence is our more constructive view on the inflation outlook relative to both markets and the Fed." The report said higher market interest rates and tighter borrowing conditions have already delivered the equivalent of several Federal Reserve rate hikes, reducing the need for additional policy action. Morgan Stanley said its financial conditions index indicates that, since the start of the Iran conflict, financial conditions have tightened by an amount equivalent to four 25-basis-point rate increases. "In essence, markets have already priced in the persistent inflation risks identified by the FOMC by pushing the implied Fed funds rate path higher," said Martin Tobias, US Interest Rate Strategist for Morgan Stanley Research. "The Fed doesn't need to deliver on the tightening in financial conditions in response to backward-looking data to retain credibility. It just needs to react to incoming information." The report also said moderating inflation, cooling housing costs, lower energy prices and a softer labour market strengthen the case for the Fed to remain on hold. For fixed-income investors, Morgan Stanley believes a stable policy environment would be supportive for government bonds and other high-quality income-generating assets. "A broadly unchanged Fed policy-rate path in 2026 and the prospect of AI-driven productivity gains should keep real yields elevated," said Vishy Tirupattur, Chief Fixed Income Strategist and Director of Quantitative Research at Morgan Stanley. The report projects the yield on the 10-year US Treasury to decline to around 4.25 per cent by the end of 2026 and 4.20 per cent in 2027 as inflation moderates. It also expects investment-grade credit to remain supported by resilient corporate fundamentals, although record debt issuance may limit broad price gains, with returns driven more by income and security selection than capital appreciation. (ANI)
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