Morgan Stanley Interprets Rate Hike: Will There Be More Rate Hikes?

TL;DR
The Federal Reserve's 25 basis point rate hike in September met expectations, but Morgan Stanley believes this action should not be simply understood as a one-time policy adjustment.
From the Fed's decision-making logic, once it ends a long pause and resumes rate hikes, the committee typically considers a series of actions rather than thinking that a 25 basis point increase is sufficient to change the macro outlook.
However, much of the current inflation stems from supply-side factors such as tariffs and energy, as well as structural demand driven by AI investments, and higher interest rates may not directly address these issues.
If inflation continues to decline in the coming months, and the PCE statistical method adjustments further lower inflation data, the Fed may have originally planned to continue raising rates but ultimately does not implement a second action.
The bond market is currently pricing in about three additional rate hikes, with the 10-year U.S. Treasury yield rising to around 5%; energy prices are becoming an important variable affecting policy expectations.

Editor's Note: After the Fed restarted rate hikes, market discussions are rapidly shifting from "Will there be a rate hike in September?" to "Is this the starting point of a new rate hike cycle?" The 25 basis points have already been implemented; what truly affects asset pricing is how many more hikes there will be, the intervals between them, and what conditions will cause the Fed to stop. However, as the consensus that "inflation is still above target, so policy needs to be tighter" gradually emerges, a more fundamental question begins to surface: If current inflation is not primarily driven by traditional demand overheating, how much can rate hikes actually solve?

In the latest issue of Morgan Stanley's "Thoughts on the Market," Chief U.S. Economist Michael Gapen and Global Macro Strategy Chief Matthew Hornbach discuss the policy path after the September rate hike from the perspectives of the economy and the interest rate market, as well as the new relationships forming between inflation, energy prices, and U.S. Treasury yields.

In this discussion, Morgan Stanley is not merely dissecting the single prediction of whether the Fed will continue to raise rates next time, but rather a set of deeper structural questions: Where does current inflation come from, where can interest rate tools exert influence, and how should the market judge how far this tightening will go?

First, the target of rate hikes has changed. In the past, typical tightening cycles often corresponded to demand overheating: strong consumption, rising wages, and credit expansion, with central banks lowering total demand by raising financing costs. However, this time, a significant portion of inflation comes from energy, tariffs, and supply-side changes, while AI investments provide new structural demand. For these factors, raising rates by 25 basis points or more may not directly suppress price pressures. This means that while the Fed can lower real estate, traditional investments, and other interest-sensitive sectors through higher rates, it may not be able to precisely address the core sources driving current inflation. Thus, policy faces a misalignment: tightening is needed, but the sectors being tightened may not be the ones creating inflation.

Second, "prepared to continue raising" and "ultimately continuing to raise" are becoming two different questions. According to Gapen's judgment, the Fed will not initiate rate hikes because it believes that 25 basis points are sufficient to change the macro outlook. Once it ends a long pause and takes action again, decision-makers typically preset that there will be a series of adjustments afterward. Therefore, from the pre-policy logic perspective, this rate hike does not seem like an isolated operation; there is at least one to two further actions possible. However, monetary policy is ultimately determined by data. If annualized inflation continues to decline over the next few months, the Fed may maintain hawkish rhetoric but choose not to act when a real decision is needed. At that point, "one and done" is not the initial design but a result of data changes.

Third, the variables determining the next rate hike are shifting from employment to the composition of inflation, especially energy prices. In the past, the market was accustomed to trading the Fed around non-farm payrolls, unemployment rates, and wage data, but Morgan Stanley believes that the current labor market is neither strong enough to create significant inflation pressure nor weak enough to force the Fed to quickly pivot. In contrast, fluctuations in Brent crude oil, WTI, and gasoline prices are more directly changing the market's pricing of the policy path: when energy prices rise, the market tends to increase rate hike expectations; when energy prices fall, hawkish pricing weakens. This means that in the coming months, judging Fed policy cannot solely rely on "how strong the economy is" but must also consider which prices are driving inflation and whether these prices are sensitive to interest rates.

Fourth, the core of trading in the U.S. Treasury market remains the policy path rather than the total debt itself. The U.S. federal debt has grown from about $31 trillion to $40 trillion, without mechanically corresponding to a continuous rise in the 10-year yield. Hornbach emphasizes that more important than the absolute scale of debt is whether the debt expansion exceeds market expectations. Conversely, this year, the 10-year U.S. Treasury yield rose from about 4.25% to 5%, with the more direct background being the market's shift from pricing two rate cuts to pricing multiple rate hikes. Therefore, long-term rates are not simply trading on "the U.S. debt is increasing," but are reassessing the balance between future monetary policy, inflation, and Treasury supply.

If this discussion can be compressed into a judgment, it is that the Fed is not subjectively starting this round of action based on "one rate hike," but the current inflation structure determines that this tightening may ultimately be prematurely terminated by data.

In this sense, the market is now discussing not just whether the next FOMC will raise rates by another 25 basis points, but a more important question: As inflation is increasingly driven by supply shocks and structural investments, to what extent can traditional interest rate tools still dominate the inflation and asset price cycle?

Key Points of the Discussion

The Federal Reserve ended a long pause and raised rates by 25 basis points at the September meeting.

However, for the market, the truly important question is not the 25 basis points itself, but: Is this merely a policy calibration, or does it mean more rate hikes are on the way?

Morgan Stanley Chief U.S. Economist Michael Gapen and Global Macro Strategy Chief Matthew Hornbach believe in the latest issue of "Thoughts on the Market" that from the Fed's own policy logic, this rate hike is likely not designed as a "one-time increase."

On the other hand, the sources of current inflation and the data trends in the coming months may lead to this round of rate hikes ultimately becoming a de facto "one and done" in hindsight. In other words, the Fed may be prepared to continue raising rates, but may not actually be able to do so in the end.

Why Raise Rates Again Now? Inflation Is Not Falling Fast Enough

Gapen believes that the most direct message conveyed by this rate hike is that the speed of inflation decline has not yet reached the level the Fed wants to see. As long as inflation remains above target, the most direct policy tool available to the Fed is still to tighten monetary policy.

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

Morgan Stanley believes that a significant portion of price pressures comes from the supply side, including tariffs, energy prices, and the ongoing trend of de-globalization over the past few years. Additionally, AI-related investments are also creating new demand pressures in some areas.

This makes the current environment different from typical demand overheating. If inflation arises from excessive consumption, credit, and investment growth, then raising interest rates can cool the economy by lowering total demand. However, if price increases mainly come from energy, trade barriers, or supply chain changes, the role that interest rates can play is much more limited.

AI investments also present a similar issue.

Investment demand in areas such as data centers, chips, and power infrastructure remains strong, and Morgan Stanley does not believe that a slight increase in interest rates can significantly reduce these structural capital expenditures.

Thus, the Fed is facing an awkward situation: it must respond to high inflation, but the rate hikes can only effectively suppress sectors that are already relatively weak and sensitive to interest rates, such as real estate and traditional investments.

This is why Morgan Stanley believes there is still significant uncertainty about whether this round of rate hikes can truly resolve the current inflation problem.

Why One Rate Hike May Not Be Enough? The Fed Typically Does Not Just Move 25 Basis Points

Despite the complex causes of current inflation, Gapen does not believe that the Fed will initiate this round of action with the mindset of a "one-time rate hike."

The reason is simple: monetary policy does not typically operate this way.

The Fed has maintained interest rates for a long time; once it decides to change the policy direction again, it usually means that decision-makers believe there has been a sufficiently significant change in the macro environment that requires a series of policy adjustments to respond.

A single change of 25 basis points is unlikely to fundamentally alter the economic and inflation outlook. Therefore, in Gapen's view, if the committee has decided to raise rates, it is highly likely that they do not think "this is enough this time" and are more likely to preset at least one to two further actions.

In other words, from the pre-policy makers' perspective, this seems more like the first step of a potential rate hike cycle rather than an isolated action.

This aligns with current market pricing. After the completion of the September rate hike, the interest rate market still implicitly expects about three additional rate hikes.

Why Might It Ultimately Only Be One Hike? Data May Hit the Brakes for the Fed

However, "the Fed is prepared to continue raising rates" does not mean that the subsequent hikes will definitely occur.

Gapen specifically distinguishes between two concepts: one is how the Fed designs policy beforehand, and the other is what actually happens in hindsight.

Currently, the annualized inflation indicators for three months and six months in the U.S. have shown a certain anti-inflation trend. If this trend continues in the coming months, a situation may arise where the Fed completes the first rate hike in September while continuing to tell the market "there is more work to do," and internally was originally prepared to raise rates one or two more times.

But when the next decision point arrives, inflation may have improved sufficiently to make a second rate hike unnecessary. In this case, looking back, this round of tightening would become a de facto "one and done"—one rate hike and then stop.

The key is that this was not the Fed's initial plan to only raise once, but rather subsequent data changed the policy path.

In the coming months, another factor that may influence policy judgment is the U.S. Bureau of Economic Analysis's adjustment to the PCE inflation data methodology.

Morgan Stanley expects that some statistical changes, including software quality adjustments, may lead to a long-term average decrease of about 0.1 percentage points in the measured year-on-year inflation rate, or even slightly more. While 0.1 percentage points may seem small, when monetary policy is on the edge of "should we raise again?" this change could have practical significance.

This is also why Gapen believes that even if the Fed continues to raise rates, this round of tightening may not evolve into a series of rapid hikes in three or four consecutive meetings. In contrast, a slower pace, such as close to once a 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.

Thus, it is entirely possible that this year will see a scenario where the Fed raises rates once in September, then remains watchful, ultimately not taking further action due to inflation improvement.

What to Watch for Next? Energy Prices Are More Critical Than Employment

So, what data should be most closely monitored next? Morgan Stanley believes that the importance of the labor market is declining.

Gapen describes employment as a "second or even third layer variable" in current monetary policy. On one hand, the growth rate of U.S. wages and labor income is still slowing, showing no clear wage-inflation spiral, and does not support the judgment that "the economy is overheating again." On the other hand, the number of new jobs in recent months, if smoothed, has remained at about 50,000 to 70,000 per month.

This level is not strong, but it is also not weak enough to force the Fed to quickly halt tightening. In contrast, Hornbach believes that the bond market is now paying more attention to energy prices.

Morgan Stanley observes that when Brent crude oil, WTI, 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 straightforward. Energy prices can directly push up overall inflation and also affect the market's judgment of future inflation stickiness.

Therefore, in the current environment: oil prices may be more likely to change the market's judgment on the next rate hike than monthly employment data.

The Market Is Already Pricing in More Rate Hikes, but There Is Still Potential for Reversal

This change in policy expectations has already been clearly reflected in the U.S. Treasury market. Earlier this year, the market was pricing in two rate cuts, with the 10-year U.S. Treasury yield around 4.25%.

Now, with policy expectations completely reversed, the market has shifted from pricing two rate cuts to pricing about four rate hikes, including actions already taken, and the 10-year U.S. Treasury yield has risen to around 5%.

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

He cites an example: about four years ago, the U.S. federal debt was around $31 trillion, and at that time, the 10-year U.S. Treasury yield was once around 4.25%. Earlier this year, U.S. debt had risen to about $40 trillion, yet the 10-year yield had still returned to nearly 4.25%.

An increase of about $9 trillion in debt over four years did not lead to a significant difference in long-term rates at these two points in time. Hornbach thus believes that the market is more concerned not with how "big" the debt is, but whether the speed of debt growth significantly exceeds investors' previous expectations. At least for now, the Fed's policy path remains a more direct variable affecting U.S. Treasury yields.

Therefore, the September rate hike seems more like a starting point rather than an answer. From the Fed's own decision-making logic, a single increase of 25 basis points is likely insufficient, and more rate hikes remain on the policy table. However, what truly determines whether these hikes can be implemented is not what the Fed says today, but whether the data in the coming months will change its mind.

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