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Soft landing still in play as Fed rate cuts will go 'well beyond' expectations: MS

Published 14/11/2023, 10:00 am
Updated 14/11/2023, 10:00 am
© Reuters -- The Federal Reserve's higher for longer rate regime will be followed up by a series of rate cuts starting in June next year that will go "well beyond" market expectations, Morgan Stanley says, expecting the Fed to achieve a soft landing as it embarks on the last mile to curbing inflation to target.  

Rate cut forecasts gather steam

The Fed is expected to deliver four 25 basis point cuts next year, lowering rates from 5.375% to 4.375% in 2024, Morgan Stanley forecasts, followed by eight cuts in 2025, pushing its benchmark rate to 2.375% by the end of 2025. 

That is above current market expectations for the Fed funds rate to end next year in a range of 4.50% to 4.75%, or 4.625% at the midpoint, suggesting three rate cuts for next year. And well above the Fed's own projections for two rate cuts in 2024.     

Others, however, have opted for a bolder forecast, with UBS expecting 275 basis points of cuts next year, while Goldman Sachs maintained a more cautious outlook calling for a single rate cut starting in Q4 next year.

Soft landing remains in play as 'labor hoarding' to underpin job market 

Expectations for deeper rate cuts than expected will likely be driven by the slowdown in economy economic growth, brought on by the Fed's higher for longer interest rate regime.

But this slowdown, Morgan Stanley forecasts, will be kept in check by a labor market that will underpin consumer spending as companies hoard workers and more people join the workforce.  

"We see job growth slowing into 2024 and 2025, but labor hoarding will help keep the unemployment rate low, underpinning our call for a soft landing," Morgan Stanley said, forecasting GDP to slow from an estimated 2.5%  in 2023 to 1.6% in 2024, and 1.4% in 2025. 

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Supply-chain healing, tighter financial conditions to feed disinflation cycle 

As the Fed stares down the last mile on inflation, the central bank can count on two main forces to extend the disinflation trend: Lagged effect of supply-chain healing throughout 2024 and softer demand. 

The improvements in the global supply-chain -- that was clogged up during the pandemic and contributed to a surge in good prices -- will continue the disinflation trend, led by falling goods prices at a time when consumer demand is also on the wane. 

"We expect negative monthly prints in core goods inflation through the forecast horizon," Morgan Stanley said.

What about 'sticky' services inflation as Fed sets off on last mile to inflation target?

While an ongoing slowdown in goods inflation will be welcomed by many, the Fed has signaled out "super core" inflation, or services inflation excluding-housing, as its main focus, and pointed to the labor market and wages as a key source of price pressures. 

But Morgan Stanley believes the link between labor markets and inflation has been less clear.

Transportation services, which is less affected by wage pressures and more by auto insurance premiums, the bank says, has been one of the major drivers of "super core" inflation and fortunately for the Fed is likely slow. 

Car insurance companies have ramped up their premiums to soften the blow to margins from the impact of historically high losses, but going forward, high car insurance costs will eventually recede to "historical rates as companies finish resetting insurance premiums," Morgan Stanley said.

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"We see core PCE inflation slowing from 3.5% in 2023 to 2.4% next year, and to 2.1% in 2025." it added.

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