Two Paths for the Fed

Apr 16, 2024

Amid robust growth and persistent inflation, the Federal Reserve faces a tough decision on how to approach rate cuts. What should investors expect?

Lisa Shalett

Key Takeaways

  • Recent data makes it clear that inflation is no longer slowing, undermining the case for the Fed to begin cutting rates in June.
  • The central bank could either keep rates high, causing potential pain for certain sectors, or preemptively cut rates, risking policy predictability.
  • Investors may want to consider rebalancing their portfolios, taking profits in richly valued equities and adding yield and value.

The S&P 500 Index has struggled in the opening days of the second quarter, down about 2.5% so far for April after double-digit gains in the first quarter. Bond yields, meanwhile, have risen back to the elevated levels they reached in November, when the 10-year Treasury rate hovered above 4.5%, with their prices dropping in tandem.


What’s driving this re-pricing? Inflation is no longer slowing—and hasn’t been for months now. That makes it less likely that the U.S. Federal Reserve will begin cutting interest rates in June, as many investors had widely expected as recently as a couple of weeks ago.


In fact, inflation, as measured by year-over-year rises in the headline consumer price index (CPI), has been higher than the June 2023 cycle low of 3.0% in every month since. Last week’s March CPI report showed headline inflation rose at a 3.5% annual clip, while the “core” metric, which excludes food and energy prices, was up 3.8%—both above the Fed’s 2% target. In addition, “super-core” inflation, which strips out housing prices as well as food and energy, accelerated to 4.8% year-over-year—the highest level in 11 months.


Meanwhile, global economic growth continues to trend higher than expected, while oil prices have soared along with many cyclical and industrial commodities.


Amid this growth and undeniably sticky inflation, much rides on the Fed’s next move. What should it do from here? Morgan Stanley’s Global Investment Committee sees two paths for the central bank, each with its own risks.

  1. 1
    The Fed keeps rates higher for longer.

    As more investors now expect, Fed officials could delay rate cuts, waiting for demand and inflation to cool first. In this scenario, higher-for-longer rates could bring pain to certain sectors of the economy, such as commercial real estate borrowers and their regional bank underwriters. Middle- and lower-income consumers who are dependent on credit cards, small business owners who need to borrow funds and home buyers in need of new mortgages would also likely struggle. Some investors might suffer, too, as higher rates tend to weigh on both stock and bond valuations.

  2. 2
    The Fed preemptively cuts rates.

    Alternately, the Fed may move before it’s clear that economic activity is cooling—cutting rates and slowing the pace at which it is shedding the massive amounts of Treasury debt and other securities that it began purchasing to stimulate the economy in 2020.


    Dovish Fed leaders may prefer this scenario, but it carries the long-term risk of undermining the Fed’s credibility. Remember, the Fed’s dual mandate is to pursue maximum employment and price stability. But if it preemptively eases policy, that could fan the flames of inflation and further erode price stability. Such an outcome would also likely reveal that this Fed appears primarily concerned with maintaining easy financial conditions, which have helped increase stock valuations and squash market volatility. 

Implications for Investors

In short, the Global Investment Committee believes this Fed has a bias toward easing policy. Not surprisingly, given this view, Fed officials seem to consider inflation as the result of various supply shortfalls in the economy, rather than coming from demand fueled by factors like aggressive fiscal spending and excessive growth in the money supply.


This bias is now being tested, and odds are rising that the Fed’s apparent objectives around financial liquidity and market stability will be exposed. In this environment, investors may want to pursue portfolio diversification and active management.


In particular, the recent rise in rates once again provides opportunities to rebalance portfolios, taking profits in richly valued equities while adding some exposure to high-quality fixed income without much need to invest in longer-duration assets to find attractive yields.


Additionally, investors should consider hedging higher inflation with commodities and real assets, including infrastructure, select real estate investment trusts (REITs) and master-limited partnerships (MLPs).


This article is based on Lisa Shalett’s Global Investment Committee Weekly report from April 15, 2024, “Crossroads or Cross Purposes?” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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