Why the Fed Will Cut Late, But Cut More

Our Global Head of Macro Strategy Matt Hornbach and U.S. Economist Michael Gapen assess the Fed’s path forward in light of inflation and a weaker economy, and the likely market outcomes.

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Matt 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. 

Matt Hornbach: Today we're discussing the outcome of the June Federal Open Market Committee meeting and our expectations for rates, inflation, and the U.S. dollar from here. 

It's Thursday, June 26th at 10am in New York. 

Matt Hornbach: Mike, the Federal Reserve decided to hold the federal funds rate steady, remaining within its target range of 4.25 to 4.5 percent. It still anticipates two rate cuts by the end of 2025; but participants adjusted their projections further out suggesting fewer cuts in 2026 and 2027. 

You, on the other hand, continue to think the Fed will stay on hold for the rest of this year, with a lot of cuts to follow in 2026. What specifically is behind your view, and are there any underappreciated dynamics here? 

Michael Gapen: So, we've been highlighting three reasons why we think the Fed will cut late but cut more. The first is tariffs introduce differential timing effects on the economy. They tend to push inflation higher in the near term and they weaken consumer spending with a lag. If tariffs act as a tax on consumption, that tax is applied by pushing prices higher – and then only subsequently do consumers spend less because they have less real income to spend. So, we think the Fed will be seeing more inflation first before it sees the weaker labor market later. 

The second part of our story is immigration. Immigration controls mean it's likely to be much harder to push the unemployment rate higher. That's because when we go from about 3 million immigrants per year down to about 300,000 – that means much lower growth in the labor force. So even if the economy does slow and labor demand moderates, the unemployment rate is likely to remain low. So again, that's similar to the tariff story where the Fed's likely to see more inflation now before it sees a weaker labor market later. 

And third, we don't really expect a big impulse from fiscal policy. The bill that's passed the house and is sitting in the Senate, we’ll see where that ultimately ends up. But the details that we have in hand today about those bills don't lead us to believe that we'll have a big impulse or a big boost to growth from fiscal policy next year. 

So, in total the Fed will see a lot of inflation in the near term and a weaker economy as we move into 2026. So, the Fed will be waiting to ensure that that inflation impulse is indeed transitory, but a Fed that cuts late will ultimately end up cutting more. 

So we don't have rate hikes this year, Matt, as you noted. But we do have 175 basis points in rate cuts next year. 

Matt Hornbach: So, Mike, looking through the transcript of the press conference, the word tariffs was used almost 30 times. What does the Fed's messaging say to you about its expectations around tariffs? 

Michael Gapen: Yeah, so it does look like in this meeting, participants did take a stand that tariffs were going to be higher, and they likely proceeded under the assumption of about a 14 percent effective tariff rate. So, I think you can see three imprints that tariffs have on their forecast.

First, they're saying that