Morgan Stanley on the Fed Hike: Will There Be More?

TL;DR
· The Fed's 25 basis point hike in September was expected, but Morgan Stanley believes this move should not be simply understood as a one-off policy adjustment.
· From the Fed's decision-making logic, once it ends a long pause and resumes hiking, the committee typically considers a series of actions, rather than thinking 25 basis points is enough to change the macro outlook.
· However, a large part of current inflation comes from supply-side factors such as tariffs and energy, as well as structural demand from AI investment, and higher rates may not directly solve these problems.
· If inflation continues to fall in the coming months, and PCE methodology adjustments further lower inflation data, the Fed may have been prepared to continue hiking but ultimately not implement a second move.
· The bond market is still pricing in about three additional hikes, with the 10-year Treasury yield rising to around 5%; energy prices are becoming an important variable affecting policy expectations.

Editor's note: After the Fed resumed rate hikes, market discussion is rapidly shifting from "whether to hike in September" to "whether this is the start of a new hiking cycle." The 25 basis points themselves have already landed; what truly affects asset pricing is how many more hikes there will be, how far apart, and what conditions will make the Fed stop. But as "inflation is still above target, so policy needs to be tighter" gradually becomes consensus, a more fundamental question begins to emerge: if current inflation is not primarily driven by traditional demand overheating, then how much can rate hikes actually solve?

In the latest episode of Morgan Stanley's "Thoughts on the Market," Chief US Economist Michael Gapen and Global Head of Macro Strategy Matthew Hornbach discuss the policy path after the September hike, and the new relationship forming among inflation, energy prices, and Treasury yields, from both economic and rates market perspectives.

In this conversation, what Morgan Stanley really dissects is not the single forecast of "whether the Fed will hike again next time," but a set of more fundamental structural questions: where current inflation comes from, where the interest rate tool can act, and how the market should judge how far this tightening will go.

First, the target of rate hikes has changed. Past typical tightening cycles often corresponded to demand overheating: strong consumption, rising wages, credit expansion, and central banks lowering aggregate demand by raising financing costs. But this time, a considerable portion of inflation comes from energy, tariffs, and supply-side changes, while AI investment provides new structural demand. For these factors, raising rates by 25 basis points or more may not directly suppress price pressures. This means that although the Fed can cool housing, traditional investment, and other interest-rate-sensitive sectors through higher rates, it may not be able to precisely address the core sources driving current inflation. Policy thus faces a mismatch: tightening is needed, but the sectors being tightened are not necessarily the ones creating inflation.

Second, "prepared to continue hiking" and "ultimately continuing to hike" are becoming two different questions. According to Gapen's judgment, the Fed would not start raising rates because it thinks 25 basis points is enough to change the macro outlook. Once it ends a long pause and acts again, policymakers usually assume there will be a series of adjustments afterward. Therefore, from the ex-post policy logic, this hike does not look like an isolated operation, and there is at least room for one to two further moves. But monetary policy is ultimately determined by data. If three-month and six-month annualized inflation continue to decline in the coming months, the Fed could very well maintain hawkish rhetoric but choose not to act when a decision is actually needed. At that point, "one and done" is not the original design, but the result of data changes.

Third, the variable determining the next hike is shifting from employment to the composition of inflation, especially energy prices. In the past, the market was accustomed to trading the Fed around nonfarm payrolls, unemployment rate, and wage data, but Morgan Stanley believes the labor market is currently neither strong enough to recreate significant inflation pressure nor weak enough to force the Fed to pivot quickly. In contrast, fluctuations in Brent crude, WTI, and gasoline prices are more directly changing the market's pricing of the policy path: when energy rises, the market tends to increase rate hike expectations; when energy falls, hawkish pricing weakens. This means that in the coming months, judging Fed policy cannot just look at "whether the economy is strong," but also at what prices are driving inflation and whether those prices are interest-rate-sensitive.

Fourth, the core of the Treasury market's trading is still the policy path, not the total amount of debt itself. US federal debt has grown from about $31 trillion to $40 trillion, and this has not mechanically corresponded to a sustained rise in the 10-year yield. Hornbach emphasizes that what matters more than the absolute size of debt is whether debt expansion exceeds market expectations. On the contrary, this year's rise in the 10-year Treasury yield from about 4.25% to 5% is more directly driven by the market shifting from pricing two rate cuts to pricing multiple hikes. Long-term rates are therefore not simply trading "US debt is getting bigger and bigger," but reassessing the balance among monetary policy, inflation, and Treasury supply over the next few years.

If this conversation is compressed into one judgment, it is: the Fed subjectively did not start this round of action based on "one hike," but the current inflation structure determines that this tightening could very well be terminated early by data.

In this sense, what the market is now discussing is no longer just whether the next FOMC will add another 25 basis points, but a more important question: when inflation is increasingly driven by supply shocks and structural investment, to what extent can traditional interest rate tools still dominate inflation and asset price cycles.

The following is the original content (edited for readability):

Key Takeaways from the Conversation

The Fed ended its long pause and resumed hiking by 25 basis points at the September meeting.

But for the market, the truly important question is not the 25 basis points themselves, but: is this just a policy calibration, or does it mean more hikes are on the way?

Morgan Stanley Chief US Economist Michael Gapen and Global Head of Macro Strategy Matthew Hornbach argue in the latest "Thoughts on the Market" that, from the Fed's own policy logic, this hike was most likely not designed as "just one."

But on the other hand, the sources of current inflation and the data trajectory in the coming months could make this round of hikes ultimately become a de facto "one and done" in hindsight. In other words, the Fed may be prepared to continue hiking, but may not actually be able to follow through.

Why resume hiking now? Inflation is not falling fast enough

Gapen believes the most direct message from this hike is that the pace of disinflation still has not reached the level the Fed wants to see. As long as inflation remains above target, the most direct policy tool the Fed can use is still tightening monetary policy.

But the problem is that this time inflation is not entirely from traditional economic overheating.

Morgan Stanley believes a considerable portion of price pressure comes from the supply side, including tariffs, energy prices, and the deglobalization trend that has persisted over the past few years. In addition, AI-related investment is also creating new demand pressure in some areas.

This makes the current environment different from typical demand overheating. If inflation comes from consumption, credit, and investment growing too fast, then raising rates can cool the economy by lowering aggregate demand. But if price increases mainly come from energy, trade barriers, or supply chain changes, the role interest rates can play is much more limited.

AI investment is a similar issue.

Investment demand in areas such as data centers, chips, and power infrastructure remains strong, and Morgan Stanley does not believe that small rate hikes can significantly reduce these structural capital expenditures.

Therefore, the Fed is facing an awkward situation: it must respond to high inflation, but what rate hikes can really suppress may be more in housing, traditional investment, and other already weak and more interest-rate-sensitive sectors of the economy.

This is also why Morgan Stanley believes there is still great uncertainty about whether this round of hikes can truly solve the current inflation problem.

Why might one hike not be enough? The Fed usually doesn't move just 25 basis points

Although the causes of current inflation are complex, Gapen does not believe the Fed will start this round of action with a "one-off hike" mindset.

The reason is simple: monetary policy usually does not work that way.

The Fed has kept rates unchanged for a long time. Once it decides to change policy direction again, it usually means policymakers believe the macro environment has changed enough to require a series of policy adjustments.

A single 25 basis point change is hard to fundamentally alter the economic and inflation outlook. Therefore, in Gapen's view, if the committee has decided to hike, it most likely does not think "this time is enough," but rather assumes there is room for at least 1 to 2 more moves.

That is to say: from the policymakers' ex-ante thinking, this looks more like the first step of a potential hiking cycle, not an isolated action.

This is also broadly consistent with current market pricing. After the September hike, the rates market still implies expectations of about three additional hikes.

Why might it ultimately be just one hike? Data may hit the brakes for the Fed

However, "the Fed is prepared to continue hiking" does not equal "the subsequent hikes will definitely happen."

Gapen specifically distinguishes two concepts: one is how the Fed designs policy ex ante, and the other is what actually happened when the market looks back ex post.

Currently, US three-month and six-month annualized inflation indicators have shown some disinflationary trend. If this trend continues in the coming months, a scenario may emerge: the Fed completes its first hike in September, while continuing to tell the market "there is more work to do," and internally was originally prepared to hike once or even twice more.

But by the time the next decision point arrives, inflation has improved enough that a second hike becomes unnecessary. In that case, looking back, this cycle would become a de facto "one and done"—hike once, then stop.

The key is that this is not because the Fed planned to hike only once from the start, but because subsequent data changed the policy path.

In the coming months, there is another factor that may affect policy judgment: the US Bureau of Economic Analysis's methodology adjustments to PCE inflation data.

Morgan Stanley expects that some statistical changes, including software quality adjustments, could lower measured year-over-year inflation by an average of about 0.1 percentage point over the long term, or even slightly more. 0.1 percentage point may seem small, but when monetary policy is on the edge of "whether to hike again," this change could have real significance.

This is also why Gapen believes that even if the Fed continues to hike, this cycle may not necessarily evolve into rapid hikes at three or four consecutive meetings. In comparison, a slower pace, such as roughly once per quarter, may be more reasonable.

This would give the Fed more time to observe two things: first, whether inflation itself continues to decline; second, how much the PCE data revisions will adjust the inflation path downward.

Therefore, a scenario is entirely possible this year: hike once in September, then stay on hold, and ultimately not act again because inflation improves.

What to watch for the next hike? Energy prices matter more than employment

So, what data deserves the most attention going forward? Morgan Stanley believes the importance of the labor market is declining.

Gapen describes employment as a "second or even third-tier variable" in current monetary policy. On one hand, US wage and labor income growth is still slowing, showing no obvious wage-inflation spiral, and does not support the judgment that "the economy is overheating again." On the other hand, if recent monthly job gains are smoothed, they are roughly around 50,000 to 70,000 per month.

This level is not strong, but not weak enough to force the Fed to stop tightening quickly. In contrast, Hornbach believes the bond market is now more focused on energy prices.

Morgan Stanley observes that when Brent crude, WTI crude, and gasoline prices rise, the market typically reprices a more hawkish Fed path; when energy prices fall, future rate hike expectations also decline accordingly.

The reason is not complicated. Energy prices both directly push up headline inflation and affect the market's judgment on future inflation stickiness.

Therefore, in the current environment: oil prices may more easily change the market's judgment on the next hike than a single month's employment data.

The market is already trading more hikes, but the path could still reverse

This shift in policy expectations is already clearly reflected in the Treasury market. Earlier this year, the market was still pricing in two Fed rate cuts, with the 10-year Treasury yield around 4.25%.

Now, with policy expectations completely reversed, the market has shifted from "two cuts" to pricing in about four hikes including the completed move, and the 10-year Treasury yield has risen to around 5%.

Hornbach believes this shows that current changes in long-term rates are highly correlated with how the market understands the Fed's future policy path. In contrast, even as US government debt continues to grow, the total amount of debt alone does not explain Treasury yields well.

He gives an example: about four years ago, US federal debt was about $31 trillion, and the 10-year Treasury yield was around 4.25% at one point. Earlier this year, US debt had risen to about $40 trillion, but the 10-year yield still returned to near 4.25%.

An increase of about $9 trillion in debt over four years did not produce a significant difference in long-term rates between these two points in time. Hornbach therefore believes the market cares less about "how big" the debt is, and more about whether the pace of debt growth significantly exceeds investors' previous expectations. At least for now, the Fed's policy path remains a more direct variable affecting Treasury yields.

So, this September hike is more like a starting point than an answer. From the Fed's own decision-making logic, a single 25 basis point move is likely not enough, and more hikes remain among the policy options. But what truly determines whether these hikes can materialize is not what the Fed says today, but whether the data in the coming months will change its mind.

If energy prices remain high and disinflation stalls, more hikes may continue to be priced in by the market; but if the disinflationary trend continues, this seemingly restarted hiking cycle may ultimately leave only this one 25 basis point move.