Morgan Stanley: US inflation is expected to rebound in the next two months, making it unlikely for interest rates to be lowered in March next year!

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2023.12.20 09:25
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Morgan Stanley pointed out that the market's expectations of interest rate cuts in March are somewhat overly optimistic. The bank believes that in the next two months, inflation may rebound and the cooling of the labor market may also be relatively slow, which could delay the timing of interest rate cuts until June.

Last week, Powell's sudden shift at the press conference of the Federal Reserve policy meeting ignited market optimism.

The market is now pricing in that the Federal Reserve will start cutting interest rates by 25 basis points from March next year, with a total of 6 consecutive cuts, totaling 150 basis points, which is twice the Fed's own expectations.

In a report released on December 19th, the team led by Ellen Zentner, Chief US Economist at Morgan Stanley, pointed out that the market's expectation of a rate cut in March is somewhat too optimistic. The bank believes that inflation may rebound in the next two months, and the timing of rate cuts may be delayed until June.

Sticky service sector inflation will lead to a rebound in inflation in the next two months

The latest data shows that the US CPI rose 3.1% year-on-year in November, slowing down from 3.2% in October, in line with expectations, indicating that inflation seems to be steadily declining.

However, analysts pointed out that sticky service sector inflation is still high, and the core PCE is expected to gradually rise in the first half of next year.

Among the service categories, inflation in financial services has slowed down, but inflation in medical services may still be higher than pre-pandemic levels. In addition, the real estate market and the car insurance market are also very hot.

Analysts predict that although the annual rate of core PCE will continue to decline, the acceleration of monthly core PCE will lead to a re-emergence of an upward trend in the 6-month average inflation rate.

Moreover, in the September summary of the Federal Reserve's economic projections, the FOMC unanimously believed that there are upward risks to inflation.

Powell has also previously stated that the core PCE inflation rate was 3.5% in the year ending October, still well above the Fed's 2% target.

Although the growth rate of core PCE has been much slower in the past six months, only 2.5%, Powell believes that given the "increased uncertainty in the economic outlook," it may be difficult for inflation to continue to maintain this downward pace.

Morgan Stanley expects upward risks to still exist in early next year.

Conditions for rate cuts have not been met, and the Fed is likely to remain on hold in March

Analysts emphasized that the US labor market still has resilience, and the decline in non-farm payrolls may be slower than expected by the market:

In terms of the labor market, we expect non-farm employment to gradually return to balance and reach near replacement levels in April 2024. The flexible labor market and the weak downward trend also indicate that the start time of rate cuts will be later than market expectations.

Analysts point out that to prompt the Fed to cut interest rates, both CPI and non-farm data need to decline simultaneously. Even if CPI does not weaken, extremely poor non-farm employment data may also trigger rate cuts. Weak inflation data, especially weak service sector data, may also lead to rate cuts by the Fed, regardless of the labor market conditions.

For January, analysts believe that the possibility of rate cuts is very low. By January 24th, the Fed does not have enough information to determine that the job is done - between today and the January meeting, CPI and non-farm data will only be released once. For the March meeting, analysts emphasized that when the FOMC meets in March, the Federal Reserve will only have data for non-farm payrolls and CPI for February. In order to cut interest rates in March, the number of non-farm jobs in February needs to be below 50,000 and the core CPI monthly rate needs to be below 0.2%.

Morgan Stanley expects that core CPI inflation will accelerate from January 2024, but it will not indicate a significant decline before the March meeting. The Federal Reserve will only have data for February, so if credit conditions do not deteriorate sharply, or if there is no data indicating an economic hard landing, the Federal Reserve may maintain interest rates at the March meeting:

At that time, we expect non-farm data to weaken, but still higher than the replacement rate (about 100,000). We believe that the lack of convincing evidence is the reason for the Federal Reserve to maintain interest rate stability.

What factors will trigger an interest rate cut in March? Weak core CPI and non-farm data in February. Assuming our forecasts for December 2023 and January 2024 are correct, a core CPI below 0.2% in February means that the 6-month inflation rate will resume growth, bringing the average closer to the level of December 2023.

If non-farm jobs in February 2024 are below 50,000, the 3-month moving average will reach 100,000, indicating a cooling rate faster than expected.

If these data do not trigger an interest rate cut, then the March FOMC meeting may send a strong signal for an interest rate cut in May.

Looking ahead, the May FOMC meeting will start on April 30th and end on May 1st, so the Federal Reserve will only have CPI and non-farm data for March.

The bank believes that a sharp decline in core CPI inflation (below 0.2%) and weak non-farm data (below 60,000) may convince the Federal Reserve to cut interest rates. However, it still depends on the economic forecast summary and the non-farm and CPI data to be released in March. Therefore, based on the current trajectory of non-farm and CPI, the probability of an interest rate cut in June is higher.