Morgan Stanley says disinflation is here, but risks to 2027 rate outlook remain

Recent U.S. inflation reports have indicated a deceleration in price pressures, prompting market participants to reduce expectations of Federal Reserve rate increases. Morgan Stanley's analysts have confirmed their view of disinflation but highlighted the potential for upside inflation risks that could impact their interest rate projections for 2027.

According to the U.S. Bureau of Labor Statistics, headline Consumer Price Index (CPI) growth slowed to 3.4% in July, down from 3.5% in June, while core CPI growth moderated to 2.5% from 2.6%. Producer Price Index (PPI) data also showed a decrease in July. The inflation updates coincided with an unexpectedly weak July nonfarm payrolls report, suggesting that the Federal Reserve may consider holding interest rates steady and waiting for further data.

Investors have responded by adjusting their expectations for Federal Reserve rate hikes in September, with the odds of the central bank maintaining rates standing at around 67%, according to the CME FedWatch tool. Morgan Stanley analysts, led by Michael Gapen, attributed this disinflation to factors such as tariff payback, energy price relief, and moderating shelter inflation.

The Federal Reserve prefers to track the core personal consumption expenditures (PCE) price index, which serves as a long-term inflation target of 2%. The analysts incorporated July's PPI data and projected July core PCE inflation at 0.23% and headline inflation at 0.14%, with annual changes of 3.27% and 3.64%, respectively. If inflation follows their baseline outlook, they anticipate core PCE inflation to decrease to 3.0% year-over-year (Y/Y) in December and 2.4% by the end of 2027.

This would lead to the Federal Reserve maintaining its stance and reducing its policy rate by 50 basis points next year, with additional cuts of 25 basis points in March and June.

However, the analysts emphasized that there are risks to their monetary policy outlook that skew to the upside. Their projections assume a full recovery from recent supply-side shocks without the emergence of a new shock. They also assume limited price pressures related to artificial intelligence demand. The analysts warned that one or both of these assumptions could be incorrect.

If inflation diminishes further in 2027 but not sufficiently to warrant rate cuts, the Federal Reserve may remain on hold. Alternatively, if disinflation is a temporary phenomenon and inflation does not decline or even increases, it could result in 50-75 basis points of rate hikes to offset previous risk management cuts made last year.

In conclusion, the data suggests that the Federal Reserve may adopt a patient approach. While disinflation is evident, the analysts remain optimistic and expect continued progress toward the 2% inflation target in the coming months.