Federal Reserve "turning hawkish"? Morgan Stanley: I've seen this episode!

The Federal Reserve is hawkish, emerging markets are feeling uneasy, but Morgan Stanley is confident.

On December 20, Morgan Stanley's U.S. economist Michael T Gapen and his team stated that the current hawkish outlook of the Federal Reserve is largely consistent with their predictions—Trump's trade and immigration policies may keep inflation elevated and delay further interest rate cuts by the Federal Reserve.

Morgan Stanley indicated that the timing and magnitude of interest rate cuts depend on the implementation progress of Trump's restrictive policies; however, the impact of these policies on economic activity may also be lagged. Therefore, although the Federal Reserve is currently hawkish, it may turn dovish later. Just like in 2018, when the Federal Reserve predicted further rate hikes but ultimately chose to cut rates as economic activity slowed.

Currently, the Federal Reserve has clearly stated that if the policies of Trump's new administration trigger inflationary pressures, the Federal Reserve will slow down the pace of unwinding restrictive policies and may even raise rates in certain circumstances.

However, Goldman Sachs believes that in the long run, the negative impact of these policies on economic growth may outweigh the short-term shock to inflation, prompting the Federal Reserve to cut rates to support the labor market. If this is the case, Goldman Sachs believes that the Federal Reserve in December this year may face a situation similar to that of December 2018.

In 2018, the Trump administration began implementing tariffs and gradually expanded the range of products and countries targeted by tariffs, with import price pressures pushing inflation to the long-unachieved 2% target. At that time, the Federal Reserve was not overly concerned about the risks of rising inflation, but the committee still believed that further tightening of policies was necessary.

In September 2018, the Federal Reserve expected to raise rates three times in 2019 and once in 2020, but by December 2018, this forecast was downgraded to two rate hikes in 2019 and one in 2020. Ultimately, as manufacturing output continued to decline, the Federal Reserve held steady and eventually shifted to cutting rates in July 2019.

Goldman Sachs: The Federal Reserve's expectations align with ours

At the FOMC meeting on December 18, the Federal Reserve cut rates by 25 basis points as expected but issued hawkish forward guidance, with the dot plot indicating only two rate cuts expected in 2025, rather than the previously anticipated four.

The Federal Reserve stated that the growth of U.S. economic activity is expected to slow slightly within the anticipated range, the unemployment rate will remain low, and inflation is significantly more resilient, thus expecting fewer rate cuts next year.

Analysts pointed out that the Federal Reserve's focus has shifted from the downside risks in the labor market to concerns about a resurgence of inflation, especially after Trump took office, as tariff increases, immigration restrictions, and loose fiscal policies will pose significant upward risks to inflationGoldman Sachs stated that the Federal Reserve's remarks do not indicate a more hawkish stance, as the Fed still has a high tolerance for inflation above its target. The latest forecast shows that inflation will not return to the target of 2% until 2027, which is a full year later than previously predicted. However, the guidance released by the Fed is still to reduce rather than increase restrictions.

Goldman Sachs added that the Fed's updated forecast is highly consistent with their expectations:

Assuming that U.S. tariffs peak in the fourth quarter of 2025 and immigration numbers drop to 1 million in 2025 and 500,000 in 2026, Goldman Sachs expects that U.S. real GDP growth will slow to below 2% next year, with lagging effects appearing in 2026, further slowing real GDP growth, while core PCE inflation remains at 2.5% and the unemployment rate hovers around the current 4.2%.

As for the Fed's interest rate cut path, Goldman Sachs expects only two 25 basis point cuts in 2025, but further cuts will continue until the rate reaches 2.6% by the end of 2026.