Morgan Stanley raises "key question": How does Warsh plan to achieve price stability?

By: Dong Jing, Wallstreetcn

The Federal Reserve announced a 25-basis-point rate hike last week, marking its first increase in three years. Markets had already fully priced in or even expected more. Morgan Stanley argues that the core issue currently lies not in the hike itself, but in the underlying logic and the future trajectory of inflation.

Seth Carpenter, Morgan Stanley's Chief Global Economist, pointed out in a recent research report: The significance of this rate hike does not lie in "what happened," but in "why it happened" and "where things will head next."

The report noted that although the Fed took rate-hike action due to the overly slow decline in inflation and rising energy prices, this resembles more of a "policy fine-tuning" to sustain the disinflation process, rather than the launch of an entirely new tightening cycle.

Chair Warsh's policy core centers on the "balance sheet" rather than purely interest rate tools. Once his working group's balance sheet reform plan is implemented, the necessity for aggressive rate hikes will significantly diminish, and the ultimate degree of policy tightening will very likely fall at the lower end of market expectations.

Inflation Cooling Falls Short of Expectations, Energy Prices Reshape Hiking Momentum

The Fed raised its policy rate by 25 basis points last week. Previously, Morgan Stanley had forecast that the Fed would most likely hold rates steady, given that inflation was moving in the right direction and assuming Chair Warsh preferred to avoid raising rates whenever possible.

However, reality broke this assumption. In its report, Morgan Stanley stated that the key indicator mentioned by Warsh at the Jackson Hole meeting and in his September press conference—the six-month inflation trend, while declining, is clearly falling too slowly for the Federal Open Market Committee (FOMC).

Furthermore, the resurgence of energy price spikes has added extra complexity. Due to supply disruptions and the return of risk premiums, oil prices have not been as mild as expected. Facing an overly slow disinflation process and clear upside risks from energy prices, the FOMC ultimately decided to take action.

Committee Will Takes Precedence, Dot Plot Releases "Directional" Signals

Morgan Stanley pointed out that although Warsh explicitly stated in public comments before his appointment that he believes inflation running above target is due to the Fed's balance sheet rather than interest rates, the FOMC's traditional interest rate tool has clearly taken center stage. Policy decisions are made by FOMC vote; the new chair holds significant influence but cannot immediately and completely alter this decision-making process.

As early as the June dot plot, a considerable number of members leaned toward further tightening, with even three members voting in favor of a rate hike. Therefore, the September rate hike was not merely Chairman Warsh's personal decision, but also a reflection of the majority stance within the committee—a significant portion of members were unwilling to declare victory over inflation too prematurely.

Morgan Stanley warned against overinterpreting the dot plot. The current median expectation shows only one more rate hike on the table, while retaining the option for a second. The dot plot is best viewed as a "directional signal" rather than a firm prediction: if inflation fails to improve sufficiently, the Fed remains willing to tighten further. Additionally, the distinction between members with and without voting rights next year is crucial; most members with voting rights next year may wish to push interest rates higher.

Policy Fine-Tuning Rather Than Framework Shift, Markets May Overestimate the Magnitude of Rate Hikes

Is the September rate hike the start of a new tightening cycle, or a correction within the current framework?

Morgan Stanley believes it is the latter. The Fed's statement indicates that this move aims to bring inflation back to target in a "timelier" manner. The direction of inflation is correct; the Fed simply wishes the progress to be slightly faster. This is not a declaration that previous policies were fundamentally flawed, but merely a quantitative adjustment.

This gives rise to the "key question" posed by Morgan Stanley: How does Warsh intend to achieve price stability? Warsh has consistently emphasized the balance sheet as the core factor driving inflation, yet the balance sheet was entirely absent from his September press conference. This contradiction strengthens the possibility that:

the number of rate hikes priced into market expectations may exceed what this Fed administration will actually deliver. Once Warsh's working group completes its work, balance sheet reforms could directly reduce the need for aggressive rate hikes.

Overall, while heightened concerns about inflation have prompted the Fed to act, this appears more like a recalibration to maintain the disinflation process (which markets often refer to as unwinding last year's "insurance cuts"). The U.S. economy can absorb these rate hikes.

Morgan Stanley concludes that if the disinflation process continues as anticipated, the degree of policy tightening sought by the Fed will become clearer and will very likely sit at the lower bound of market expectations.