Morgan Stanley Forecasts Fed Will Not Raise Rates in 2026

Morgan Stanley’s chief global economist Seth B. Carpenter maintains that the Federal Reserve will not raise interest rates in 2026, citing recent labor market weakness and a downward trajectory for inflation [1, 3]. This outlook contrasts with internal Federal Reserve projections from earlier in the year, where half of the 18 voting officials indicated at least one potential rate hike remained on the table [3, 6].

Policy Divergence and Economic Data

The firm’s baseline forecast relies on the recent non-farm payroll data, which arrived significantly below expectations, providing the Federal Reserve with room to remain on the sidelines [3]. Carpenter noted that the firm’s internal inflation models sit well below the FOMC’s median expectations, bolstered by potential adjustments to the PCE (Personal Consumption Expenditures) price index calculation that could further suppress reported inflation readings [6].

While market participants have priced in higher tightening, Morgan Stanley’s strategy team suggests the current market pricing remains overly aggressive [3]. Consequently, the bank has advised investors to bet on a steepening yield curve, specifically targeting an expansion in the spread between 7-year and 30-year U.S. Treasury notes [6]. This spread was trading near 65 basis points as of early July, with the firm setting a target of 100 basis points [3].

Differing Views on Forward Guidance

The debate over future policy is complicated by shifting communication styles within the Fed. While Fed Chair Kevin Warsh has signaled a move away from rigid "forward guidance" in favor of data-dependent decision-making, other officials like Governor Christopher Waller maintain that signaling future rate paths remains a valuable tool [3, 6]. Waller cautioned that while forward guidance helped tighten financial conditions during the pandemic, it can become a liability if officials remain too rigid during periods of rapidly changing inflation [6].

Beyond the U.S., the policy landscape remains bifurcated. Morgan Stanley expects the European Central Bank to proceed with a 25-basis-point hike in September, driven by concerns over historical policy lags and the need to maintain inflation targets [1]. In contrast, the U.S. central bank faces a more complex environment where AI-driven capital expenditure and productivity gains are being debated as potential factors that could push the neutral real interest rate higher, potentially complicating the case for future easing [1].

What to watch

• PCE Inflation Data: Monitor upcoming adjustments to the PCE statistical methodology, which Morgan Stanley expects could significantly lower headline inflation readings [3].
• Treasury Yield Curve: Watch the 7-year to 30-year Treasury spread; the firm’s target of 100 basis points serves as a benchmark for their view that market pricing for Fed tightening is currently too high [3].
• Labor Market Reports: Future non-farm payroll releases will be critical, as the recent "significantly lower" reading remains the primary justification for the bank's pause forecast [6].

Whether the Federal Reserve can sustain its current policy stance depends on whether the recent cooling in employment data proves to be a durable trend or a temporary anomaly in an otherwise robust economy.