Morgan Stanley Raises a 'Key Question': How Does Warsh Plan to Achieve Price Stability?
Morgan Stanley believes that last week's interest rate hike by the Federal Reserve was merely a 'policy adjustment.' Warsh's real trump card in combating inflation lies in 'balance sheet' reform, rather than solely relying on interest rate tools. Once the balance sheet reduction plan is implemented, the necessity for aggressive rate hikes will significantly decrease, and the final tightening is likely to fall at the lower end of market expectations.
Written by: Dong Jing, Wall Street Insights
Last week, the Federal Reserve announced a 25 basis point interest rate hike, marking its first increase in three years, which the market had already fully priced in, even expecting more. Morgan Stanley believes that the current focus is not on the rate hike itself, but on the logic behind it and the future path of inflation.
Seth Carpenter, Chief Global Economist at Morgan Stanley, pointed out in a recent research report that the significance of this rate hike lies not in 'what happened,' but in 'why it happened' and 'where it is headed next.'
The report notes that although the Federal Reserve took action to raise rates due to slow inflation decline and rising energy prices, it is more akin to a 'policy adjustment' to maintain the disinflation process rather than the start of a new tightening cycle.
The core of Federal Reserve Chair Warsh's policy is centered on the 'balance sheet' rather than solely on interest rate tools. Once the balance sheet reform plan from his working group is implemented, the necessity for aggressive rate hikes will significantly decrease, and the final degree of policy tightening is likely to fall at the lower end of market expectations.
Inflation Cooling Slower Than Expected, Energy Prices Reshape Rate Hike Motivation
Last week, the Federal Reserve raised the policy rate by 25 basis points. Previously, Morgan Stanley had anticipated that, as inflation was moving in the right direction and assuming Chair Warsh preferred to avoid rate hikes as much as possible, the Fed would likely remain on hold.
However, reality shattered this assumption. Morgan Stanley stated in its report that the key indicators mentioned by Warsh at the Jackson Hole meeting and the September press conference—the six-month inflation trend—are declining, but the pace of decline is clearly not fast enough for the Federal Open Market Committee (FOMC).
Additionally, the renewed surge in energy prices has added extra complexity. Due to supply disruptions and the re-emergence of risk premiums, oil prices have not moderated as expected. Faced with a slow disinflation process and clear upward risks in energy prices, the FOMC ultimately decided to take action.
Committee Will Dominates, Dot Plot Releases 'Directional' Signals
Morgan Stanley pointed out that although Warsh clearly stated in his public comments before his appointment that he believes the reason for inflation being above target is the Federal Reserve's balance sheet rather than interest rates, the traditional interest rate tools of the FOMC currently hold the upper hand. Policy decisions are made by FOMC votes, and while the new chair has significant influence, he cannot immediately and completely change this decision-making process.
As early as the dot plot in June, a considerable number of committee members leaned towards further tightening, and in July, three even voted against the rate hike. Therefore, the September rate hike was not only Warsh's personal decision but also a reflection of the majority stance within the committee—many members are unwilling to declare victory over inflation too early.
Morgan Stanley warns against overinterpreting the dot plot. Currently, the median expectation only indicates one more rate hike, while retaining the option for a second hike. The dot plot is best viewed as a 'directional signal' rather than a precise prediction: if inflation does not improve sufficiently, the Fed is willing to tighten further. Moreover, the distinction between voting and non-voting members next year is crucial, as most voting members may wish to push rates to higher levels.
Policy Adjustment Rather Than Framework Change, Market May Overestimate Rate Hike Magnitude
Is the September rate hike the beginning of a new tightening cycle, or a correction within the current framework?
Morgan Stanley believes it is the latter. The Federal Reserve's statement indicates that this move aims to bring inflation back to target in a 'more timely' manner. The direction of inflation is correct; the Fed simply hopes to speed up the pace a bit. This does not declare that previous policies were fundamentally flawed, but rather is an adjustment in degree.
This leads to the 'key question' posed by Morgan Stanley: How does Warsh plan to achieve price stability? Warsh has consistently emphasized that the balance sheet is the core driver of inflation, yet he completely omitted mentioning the balance sheet in the September press conference. This contradiction reinforces a possibility:
The number of rate hikes expected by the market may exceed the number that this Federal Reserve will actually deliver. Once Warsh's working group completes its relevant work, balance sheet reform may directly reduce the necessity for aggressive rate hikes.
Overall, the Federal Reserve's concerns about inflation have intensified and it is willing to take action, but this is more like a recalibration to maintain the disinflation process (which the market often refers to as unwinding last year's 'insurance rate cuts'). The U.S. economy can withstand these rate hikes.
Morgan Stanley believes that if the disinflation process continues as expected, the degree of policy tightening sought by the Federal Reserve will become clearer and is likely to be at the lower end of market expectations.
-- Price
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