Why the Fed May Have Further to Go

After raising interest rates for the first time in more than three years, the Fed still doesn’t see policy as restrictive. Our Global Head of Fixed Income Research Andrew Sheets breaks down what that could mean for the monetary policy path.

Read more insights from Morgan Stanley.

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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Fixed Income Research at Morgan Stanley.

Today, why the Federal Reserve may have raised interest rates and yet still thinks that monetary policy is providing support.

It's Thursday, September 17th at 2pm in London.

Yesterday, the Federal Reserve raised interest rates by a quarter of a percent. That part was widely expected. What was more notable was how Chair Warsh described it.

At the press conference following the action, he said that the Fed had removed "a dose of accommodation," and he said that both he and many of his colleagues were hard-pressed to describe broader financial conditions as restrictive.

That's an important distinction that now moves to the heart of the market debate.

If monetary policy is already restrictive, another rate hike means that the Fed is pressing harder on the proverbial brakes on the economy. But if policy is still accommodative, a hike is more like easing off the gas. It means the Fed is simply providing a little less support. And if that is how the committee sees the world, it suggests that there could be further to go.

Following yesterday's meeting, Morgan Stanley's economists now expect two additional quarter point rate hikes in December and March, taking the Fed's target rate range from 4.25 to 4.5 percent; and we then expect those rates to remain there through the rest of 2027.

Three things are driving this updated view.

First is exactly that language around accommodation. The interest rates that keep the economy in balance are always a mystery when viewed in real time. But given booming earnings growth, loan growth, and corporate activity, it's not obvious that the current level of interest rates are holding back activity for the economy as a whole. The Fed may believe that as well, making higher rates a little more palpable.

Second is inflation. Chair Warsh repeatedly emphasized that trends matter here more than individual data points, and on that basis, inflation still looks too high. Too many categories are still running above 3 percent. The Fed simply does not sound convinced that inflation is moving sustainably back towards its 2 percent target as fast as it would like.

Third is geopolitics. Chair Warsh explicitly cited geopolitical developments as one of the things that had changed since their meeting in July. He also made it clear that the Fed is watching not just high oil prices, but so-called second-round effects. And whether higher prices for fuel translate into higher prices for things that require a lot of fuel.

Airline tickets, for example, are one of the areas of the economy where prices are going up the fastest. Higher oil prices are a key reason why. And so with energy markets still severely disrupted, this remains a wild card.

There is, maybe, one other wrinkle. The committee also raised its estimate of the so-called long-run neutral interest rate – the rate that it thinks we'll ultimately end up at over the long term that will keep the economy in balance. And it raised this to about 3.25 percent.

This is an uncertain estimate, and Chair Warsh himself downplayed its importance. But directionally, a view that the interest rate that keeps things in balance is higher means that any given interest rate that we see today is less restrictive on economic growth.

It's less elevated relative to that neutral rate than we previously thought. That, too, leans towards the case for more tightening and more rate increases rather than less.

None of this is set in stone. If energy prices fall, geopolitical tensions ease, or inflation improves more quickly, the Fed could stop earlier. But for now, we think the important message from this week's meeting was not simply that the Fed raised rates.

It was that even after doing so, it still doesn't think that policy is especially tight. And if that's right, there may be still more to do.

Thank you, as always, for your time. If you find Thoughts the Market useful, let us know by leaving a review wherever you listen. And also tell a friend or colleague about us today.