Morgan Stanley maintains a base case in which the Federal Reserve moves toward rate reductions in 2026, despite a recent uptick in headline inflation that the bank attributes largely to higher energy prices. The firm says the decisive variable for policymakers is not the headline figure but whether longer-term inflation expectations remain anchored.
In its note, Morgan Stanley highlights that short-term expectations - such as one-year measures - have risen, but interprets this shift as a response to temporary energy-related pressures rather than a durable re-acceleration of inflation dynamics. By contrast, long-run expectations that the Fed monitors closely have been relatively stable and remain close to levels seen before the pandemic, the bank says, indicating that credibility on inflation control has not been significantly eroded.
The bank's forecast assumes a muted pass-through from elevated oil prices into core inflation, which excludes food and energy. Given that assumption, Morgan Stanley expects the Fed to be willing to "look through" the current energy-driven spike in headline inflation provided underlying measures of price growth continue to show progress.
Separately, the note points to a sizable tightening in financial conditions since the onset of the Middle East conflict. Morgan Stanley quantifies the combined effect of a stronger dollar, higher oil prices and rising equity risk premiums as roughly equivalent to an 80 basis point increase in policy rates. That market-driven tightening, the bank argues, lessens the need for the central bank to add further policy restraint on top of existing levels.
Against that backdrop, Morgan Stanley projects that the Fed will begin easing policy later in 2026, most likely in the second half of the year as economic growth slows and inflation eases. The firm expects two cuts of 25 basis points each, which would move the federal funds rate toward a range of about 3.0% to 3.25%.
However, Morgan Stanley emphasizes that its outlook is contingent on inflation expectations remaining well-anchored. If long-term expectations were to rise persistently, the bank warns, the Fed could be compelled to keep rates elevated for longer, particularly if energy shocks start to feed into broader price-setting behavior across the economy.
For now, Morgan Stanley's analysis indicates that the recent oil shock - while material for financial markets and household budgets - is unlikely to overturn the projected easing path for policy makers, provided the upward pressure on headline inflation proves temporary and underlying inflation metrics continue to improve.
Summary
Morgan Stanley expects Fed rate cuts in the second half of 2026 despite an oil-driven spike in headline inflation, arguing that long-term inflation expectations remain anchored, pass-through to core inflation should be limited, and financial conditions have tightened materially.
- Expected timing: Easing begins later in 2026, with cuts in the second half of the year.
- Projected path: Two 25-basis-point cuts bringing rates toward 3.0% - 3.25%.
- Policy consideration: Fed focus is on long-run inflation expectations, not solely headline inflation.