Welcome to Thoughts on the Market.
I'm Matthew Hornbach, global head of macro strategy.
And I'm Michael Gapin, Morgan Stanley's chief U.S. economist.
The October FOMC meeting delivered a quarter percent rate cut, as widely expected.
But things are more complicated, and policy is not on a preset path from here.
It's Friday, November 7th, at 10 a.m. in New York.
So, Mike, the Fed did cut by 25 basis points in October, but it was not a unanimous decision.
And the Federal Open Market Committee decided to end the reduction of its balance sheet on December 1st, earlier than we expected.
How did things unfold?
And does this change your outlook in any way?
Yeah, Matt, it was a surprise to me.
Not so much the statement or the decision, but there were dissents.
There was a dissent in favor of a 50 basis point cut.
There was a dissent in favor of no cut.
And that foreshadowed The press conference where really the conversation was about, I think, a divided committee and a committee that didn't have a lot of consensus on what would come next.
The balance sheet discussion which we can get into.
It came a little sooner than we thought, but it was largely in line with our view.
And I'm not sure it's a macro critical decision right now, but I do think it was a surprise to markets.
And it was certainly a surprise to me how much Powell's tone shifted between September and October in terms of what the market could expect from the Fed going forward.
So what he said, in essence the key points, you know the policy's not on a preset path from here or cut in December is maybe not decidedly part of the baseline, or certainly is not a foregone conclusion.
And I think what that reflects is a couple of things.
One is that They're recalibrating policy based on a risk management view.
So you can cut almost independent of the data, at least in the beginning.
And so now I think Powell's saying well, at least from here, future cuts are probably more data dependent than those initial cuts.
But second, and I think most importantly, is the division that appeared within the Fed.
I think there's one group that's hawkish, one group that's dovish, and I think it reflects the division and the tension that we have in the economic data.
So I think the hawkish crowd is looking at strong activity data, strong AI spending, an upper income consumer that seems to be doing just fine.
And they're saying, why are we cutting?
Financial conditions for the business community is pretty easy.
Maybe the neutral rate of interest is higher.
We're probably less restrictive than you think.
And then I think the other side of the committee, which I believe still that Chair Powell is in, is looking at a market slowdown and hiring a weak labor market, what that means for growth in real income for those households that depend on labor market income to consume.
There was probably some front running of autos that artificially boosted growth in the third quarter.
So I think the dissents, or I should say the division within the FOMC, I think reflects the tension in the underlying data.
So to know which way monetary policy evolves Matt, it's essentially trying to decide does the labor market change, rebound towards the activity data or does the activity data decelerate, at least temporarily, to the labor market?
Mike, you talked a lot about data just now and we're not exactly getting a lot of government data at the moment.
How are you thinking about the path for the data in terms of its availability between now and the December FOMC meeting, and how do you think that may affect the Fed's willingness to move forward with another rate cut in the cycle?
Right.
So that's key and critical to understanding.
We're operating under the assumption, of course, the federal government shutdown is going to end at some point.
We're going to get all this back data released and we can assess where the economy is or has been.
I think the way markets should think about this is if the government shutdown is ended in the next few weeks, say before Thanksgiving, then I think we, markets, the Fed, will have the bulk of the data in front of them and available to assess the economy at the December FOMC meeting.
They may not have it all, but they should get at least some of that data released.
We can assess it.
If the economy has moderated and weakened a bit, the labor market has continued to cool.
The Fed can cut.
If it shows maybe the labor market rebounding, downside risk to employment being diminished, maybe the Fed doesn't cut.
So that's a world, and it is our expectation The shutdown should end in the next few weeks.
We're already at the longest shutdown on record.
So we will get some data in hand to make the decision for December.
Perhaps that's wishful thinking, Matt.
And maybe we go beyond Thanksgiving and the shutdown extends into December.
My suspicion though, is if the government is still shut down in December, I can't imagine the economy is getting better.
So I think the Fed could lean in the direction... of taking one more step.
This is going to be very critical for how the markets think about the outlook in 2026 and price the outlook for 2026.
The last FOMC meeting of the year has that type of importance for markets, pricing the path of Fed policy and pricing the path of the economy into 2026.
Because if we end up receiving a rate cut from the Fed, the dialogue in the investment community will be focused on when might the next cut arrive?
Versus if we don't get that rate cut in December.
The dialogue will focus on maybe we will never see another rate cut in the cycle, and what if we see a rate hike as we make our way through the second half of 2026.
So that can have a dramatic impact on the U.S.
Treasury market and how investors think about the outlook for policy and the economy.
So I think that's right.
And, as you know, our baseline outlook is, at least through the first quarter, if not into the second quarter, the private sector will still be attempting to pass through tariffs into prices.
And I think in the meantime, demand for labor and the hiring rate will remain low.
And so we look for additional labor market slack to build.
Not a lot, but the unemployment rate moving to more like 4.6, maybe 4.7.
And that underpins our expectation the Fed will be reducing rates in 2026.
But I think, as you note and as I mentioned earlier, there is this tension in the data and it's not inconceivable that the the labor market accelerates and you get kind of an animal spirits-driven 2026 where a combination of momentum in the data, AI-related business spending, wealth effects for upper-income consumers and maybe a larger fiscal stimulus from the One Big Beautiful Bill Act lead the economy to outperform.
And to your point if that is happening, it's not far-fetched to think.
Well, if the Fed put in risk management insurance cuts, perhaps they need to take those out.
And that could build in a way where that expectation looks say, towards the second half or the fourth quarter maybe of 2026.
Maybe it takes into 2027.
But I agree with you that if the Fed can't cut in December because the economy is doing well and the data show that and we learn more of that in 2026, you're right.
So maybe to put it more simply...
The more the Fed cuts, the more you need to open both sides of the rate path distribution, right?
The deeper they cut, the greater the probability over time they're going to have to raise those rates.
And so if the Fed is forced to stop in December, yeah, you can make that argument.
Indeed, a lot of the factors that you mentioned are factors that are coming up in investor conversations increasingly.
The way I've been framing it in my discussions is that investors are want to see the glass as half full.
Today, versus in the middle of this year, the glass was looking half empty.
And, of course, as we head into the holiday season, the glass will be filled with something perhaps a bit tastier than water.
And so... Fill my glass, please.
Indeed.
So I do think that we could be setting up for a bright 2026 ahead.
And so with that, Mike...
Look forward to seeing you again in December, with a glass of eggnog perhaps and a decision in hand for the meeting that the Fed holds then.
Thanks for taking the time to talk.
Great speaking with you, Matt.
And thanks for listening.
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