Fed in July: A Weaker Case for Hiking

Our Global Head of Macro Strategy Matthew Hornbach and Chief U.S. Economist Michael Gapen unpack what is likely to influence this week’s interest rate decision by the Fed.

Read more insights from Morgan Stanley.

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Matthew Hornbach: Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy. 

Michael Gapen: And I'm Michael Gapen, Morgan Stanley's Chief U.S. Economist. 

Matthew Hornbach: Today, will the Fed hold or hike? It's the question in the market right now. 

It's Tuesday, July 28th at 9:30am in New York. 

Will the Fed display patience, or has it run out of patience? That's the question hanging over the July FOMC meeting currently underway. 

We believe the former. We expect the Fed to keep the target range for the federal funds rate unchanged at 3.5 to 3.75 percent. The statement will probably also remain unchanged, reiterating the ample reserve policy, economic activity expanding at a solid pace despite elevated uncertainty. 

So, Mike, what's your assessment of the situation beyond that? 

Michael Gapen: Our assessment of the July FOMC meeting is actually the case for hikes is not as persuasive now as it was in June. And I think when we say that and when we come to the decision the Fed will stay on hold this week, we're basing it mainly on the data that has come in since the June FOMC meeting. And two important pieces on that front are employment growth moderated. 

So, in the June meeting, the three-month average payroll gain was running at about 188,000 per month. And I think it gave the sense that the labor market was really accelerating and there was downside risk to the unemployment rate. The subsequent employment data changed that view. Now it looks like there is much less of an acceleration in hiring and momentum has slowed. So, the labor market doesn't look quite as robust. 

Second, there was a lot of information, we think, a lot of signal about disinflation. So yes, recent volatility in the Middle East did push oil prices temporarily higher. We'll see where that goes. But underneath the hood, there was significant softness in goods inflation and services inflation, particularly related to housing. 

So, we do think that there was a lot of evidence that disinflation is here. So, with those two things in mind, we think there's less of a case to hike in July than there was in June. So, we think the right thing... Or what we think the Fed will do is to skip July, try and buy a little more time, get a little more information. If disinflation is indeed here, the Fed stays on hold. If not, and inflation stays firm, well, they can move to rate hikes later this year. 

But we think the case to hike in July is less compelling than it was in June. 

Matthew Hornbach: Well, they certainly will get a lot more information between the July meeting and the September meeting. If memory serves, at least two more rounds of all of the major economic data points… 

Michael Gapen: That’s right. 

Matthew Hornbach: Payroll, CPI, and so on. 

Michael Gapen: That's right. The gap between the July FOMC meeting and the September FOMC meeting is the longest on the Fed's calendar. Of course, in part, that makes room for Jackson Hole in August, which if the Fed were moving to a tightening cycle, could be a venue to lay out the case for that. But you're right, they will see multiple employment and inflation reports before they meet again in September. 

Matthew Hornbach: If they really wanted to get ahead of that data and move at this meeting, what is the case for hiking rates in July? How would you think about that perspective? 

Michael Gapen: I think you could make a couple of cases to hike now. One is recent volatility and conflict in the Middle East has pushed oil prices higher. Maybe it convinces you – you're in a prolonged oil risk premium scenario, and inflation will not dissipate. 

Second, I think you could argue, well, it's a balance of risks argument. And we think risks have just shifted in the direction of inflation, where last year they were in the direction of a weaker labor market. We eased last year. Let's just reverse those risk management rate cuts this year. So, it's not about inflation in hand, it's about your view of risks around inflation. 

Another, I think, and to me, this is the most important one, is maybe Warsh wants a regime change in the reaction function. In other words, he emphasizes price stability and achieving the 2 percent target. Well, at some point, words are words and actions are actions. And maybe what he desires is a more hawkish reaction function and kind of a higher interest rate all else equal to guide inflation down to 2 percent more quickly. 

So, I think, Matt, if we're wrong this week, I think the main reason we're wrong is I'm thinking under an older reaction function, and Warsh is bringing a new one. And right now, we don't exactly know what his reaction function is. And he could reveal it this week as being in a direction where he really wants to concentrate on the inflation side of the mandate to the exclusion of nearly everything else. 

Matthew Hornbach: Well, I don't think that's lost on markets at all. And in fact, I think that the rise in yields we've seen in the bond market concentrated in the real yield component of the 10-year Treasury bond tells you a lot about how investors are thinking the Fed will react to higher energy pric