Morgan Stanley strategists including Michael Gapen and Sam Coffin say the balance of risks facing Federal Reserve interest rate policy appears to be tilting toward "firmer inflation rather than weaker hiring." In a note published on Friday, the team argued that recent developments are increasing the probability that inflation risks will dominate the Fed's policy calculus.
The analysts noted that any sustained disinflation depends in part on how the joint U.S.-Israeli assault on Iran is resolved. They added that upward pressure from sweeping Trump administration tariffs appears to be "nearing completion," reducing one potential source of additional price pressure.
Data released this week showed headline consumer price growth accelerated at its fastest pace in years in May. Hotter producer price gains also pushed economists' estimates higher for the Fed's preferred inflation gauge, the core personal consumption expenditures index.
Energy costs were identified as a principal driver of the recent inflation readings. According to the note, energy prices have risen since the start of the Iran war in late February, a move that the analysts link to the months-long shuttering of the Strait of Hormuz, a key passage for global oil and liquefied natural gas shipments.
Meanwhile, the labor market has continued to strengthen despite the conflict, an outcome that Morgan Stanley says reduces the downside risks to the Fed's policy outlook. The strategists highlighted the tension policymakers face: while higher interest rates can help rein in inflation, they can also weigh on the broader economy and the labor market.
Market pricing currently suggests the Fed will keep rates unchanged at the conclusion of its upcoming two-day policy meeting next week. However, investors still expect the central bank to raise borrowing costs before the end of the year. Expectations that the Fed would begin cutting rates in early 2026 have diminished, according to the note.
Underlying these market positions is the assumption that the Fed may prioritize fighting inflation given the persistence of a strong American labor market. The Morgan Stanley team set out "two scenarios under which inflation would run higher and the Fed would either remain on hold for longer or potentially hike rates":
- "Demand push" - stronger consumption and business investment lead to reaccelerating growth and tighter labor market conditions.
- Persistent oil premium - a sustained premium on oil prices stemming from a prolonged U.S.-Iran conflict.
"The recent developments in the Middle East, together with last weeks employment report and this weeks inflation data, suggest that both scenarios may be becoming more likely than we initially anticipated," the strategists wrote. They concluded: "On net, the data indicate that the balance of risks is shifting in the direction of firmer inflation over weak hiring."
The note underscores a policy dilemma for the Fed: if inflation proves stickier because of lingering energy premiums or renewed demand, the central bank could find itself holding rates higher for longer or even raising rates further, despite the potential cost to economic growth and employment.
Key points
- The balance of Fed policy risks is shifting toward firmer inflation rather than weaker hiring, according to Morgan Stanley strategists.
- Energy price spikes linked to disruptions around the Strait of Hormuz and stronger May inflation readings are central to the downside for disinflation.
- A resilient U.S. labor market reduces the likelihood that weaker hiring will become the dominant risk for policymakers.
Risks and uncertainties
- Geopolitical risk: A prolonged U.S.-Iran conflict could sustain an oil premium, keeping inflation elevated - impacting energy and broader inflation-sensitive sectors.
- Policy risk: If inflation remains firm, the Fed may stay on hold longer or raise rates further, which could weigh on interest-rate-sensitive sectors and overall economic activity.