Morgan Stanley: The Federal Reserve's policy is unlikely to shift in the short term, and balance sheet reduction will have to wait until next year at least

The leadership changes at the Federal Reserve are unlikely to alter the direction of monetary policy in the short term. Morgan Stanley's chief economist Seth Carpenter recently stated that despite Jerome Powell's term as chairman nearing its end and the nomination of Christopher Waller as his successor, the Federal Reserve's policy reaction function will not undergo substantial changes. The FOMC meeting last week maintained the current policy, and the dissenting votes in favor of rate cuts highlighted the divisions within the FOMC. Although Waller has publicly stated that the Federal Reserve's balance sheet should be reduced, any changes will require support and consensus within the FOMC, which will delay related decisions until next year. Morgan Stanley maintains its baseline expectation of two rate cuts in the second half of this year, provided that tariff-driven inflation subsides and a clear downward trend in inflation re-emerges. The firm believes that the current large balance sheet of the Federal Reserve is a decision of the existing FOMC, and even if the new chairman wishes to reduce the balance sheet, it will take time to build consensus. Market pricing is currently aligned with this baseline expectation, but if the unemployment rate continues to decline, spending remains strong, and inflation does not decrease, the Federal Reserve may keep interest rates unchanged for the remainder of the year. FOMC Voting Mechanism Limits Policy Shifts On one hand, monetary policy decisions are made by FOMC votes, not solely by the chairman. The dissenting votes last week clearly indicated this. Although the chairman traditionally has the authority to lead the FOMC, any attempt to significantly deviate from the FOMC's standard reaction function will face multiple votes of opposition. Morgan Stanley assesses that policy changes will deviate by at most 25 basis points from the current FOMC framework. On the other hand, none of the candidates previously listed by the White House have particularly deviated from the mainstream stance on monetary policy. This is evident from their public statements. The response function of the Federal Reserve, led by Powell, during special economic periods is also not fixed; in the second half of last year, the policy focus shifted from addressing high inflation to "insurance rate cuts" based on weak employment growth. Productivity Narrative May Become a Key Variable Interpreting the economic implications of low unemployment, high inflation, and strong growth requires a clear judgment on productivity. Powell stated at a recent press conference that the FOMC believes cyclical productivity has improved but did not attribute it to artificial intelligence. If the FOMC is to be persuaded to cut rates in the context of robust economic growth, productivity will be a key argument. Former Chairman Alan Greenspan maintained interest rates in the mid to late 1990s using this argument, despite accelerating economic growth and declining unemployment at that time. However, inflation is still rising, and the overall tone of last week's Federal Reserve meeting conveyed a judgment of robust economic activity. With inflation exceeding the target for five consecutive years and the labor market potentially beginning to improve, the baseline expectation for further rate cuts is not set in stone. Morgan Stanley's constructive growth outlook, especially for the second half of the year, presents some contradictions with additional rate cuts, but the firm assumes that declining inflation will prevail. If the unemployment rate continues to decline, and business and consumer spending maintains its current strength, and inflation does not decrease after this quarter, even the Federal Reserve led by Powell will certainly question the value of accommodative policies. This combination of data will raise questions about the neutral interest rate level and whether that level has already been reached Even with leadership changes, strong spending accompanied by persistent inflation and low unemployment may keep the FOMC on hold for the remainder of this year