Fed’s Path Uncertain as Key Data Lags

Our Chief U.S. Economist Michael Gapen and Global Head of Macro Strategy Matthew Hornbach discuss potential next steps for the FOMC and the risks to their views from the U.S. government shutdown.

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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: 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 10am 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?

Michael Gapen: 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 [a] 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 in 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's probably some front running of autos that artificially boosted growth in the third quarter.

So, I think that 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 rebound towards the activity data or does the activity data decelerate at least temporarily to the labor market?

Matthew Hornbach: 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?

Michael Gapen: Right. So that's key and critical to understanding, right? We're operating under the assumption, of course the federal government shutdowns 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 has 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