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

This week's U.S. inflation reports indicated a slowdown in price pressures, leading traders to adjust their expectations for Federal Reserve rate hikes. Morgan Stanley's outlook confirmed the trend of disinflation, but cautioned that upside inflation risks could impact their interest rate projections for 2027. The U.S. Bureau of Labor Statistics reported that headline CPI growth decelerated to 3.4% in July from 3.5% in June, while core CPI growth eased to 2.5% from 2.6%.

Similarly, core PPI inflation also moderated. These developments, coupled with a weaker-than-expected July nonfarm payrolls report, suggest that the Federal Reserve may hold off on rate hikes and monitor the situation further. Morgan Stanley analysts led by Michael Gapen attributed the disinflation to tariff-payback, energy price relief, and moderating shelter inflation.

They noted that the Fed's base case is to remain patient, with softer inflation, cooling employment, and wage growth allowing for rate holdovers through the end of the year. While the CPI and PPI are commonly used inflation indicators, the Fed prefers the core personal consumption expenditures (PCE) price index, which it targets at 2%.

Morgan Stanley now projects July core PCE inflation at 0.23% and headline inflation at 0.14%, with annual changes of 3.27% and 3.64%, respectively. If these projections hold, the Fed may keep rates steady in 2027 and make a 50 basis point reduction next year, contingent on no new supply-side shocks or artificial intelligence-driven price pressures.

Morgan Stanley emphasized that while disinflation appears real, its durability and depth remain uncertain. The firm remains optimistic about progress toward the 2% inflation target but cautioned that the Fed's path forward could hinge on whether disinflation continues or unexpectedly reverses.