Disinflation Signals Confirmed; the Fed May Remain on Hold This Year
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Disinflation Signals Confirmed; the Fed May Remain on Hold This Year
Morgan Stanley believes tariff pass-through is largely complete, while lower energy prices and easing housing inflation are driving US disinflation, although oil prices, tariffs, and AI demand may still constrain the scope for rate cuts in 2027.
- July core CPI rose 0.22% month over month, while headline CPI rose 0.07% month over month, indicating moderate inflation pressure.
- July core PCE and headline PCE are expected to rise 0.23% and 0.14% month over month, respectively.
- Under the base case, the Fed will hold rates through end-2026 and cut rates by 25 basis points each in March and June 2027.
- Escalation in the Middle East has lifted oil prices; together with tariff- and AI-related price pressures, this represents the main risk of a renewed inflation pickup.
Report interpretation
Overview
The report argues that US disinflation has begun. Its foundations are largely complete tariff pass-through to end prices, lower energy prices with limited second-round effects, continued easing in housing inflation, and downward effects from seasonality and statistical methods. Recent CPI and PPI data broadly corroborate this view, but the durability of disinflation still depends on oil prices, geopolitics, tariffs, and AI-related demand pressures.
Core views
Morgan Stanley expects that the combination of weakening inflation and cooling employment and wage growth will lead the Fed to observe the disinflation process and keep the policy rate unchanged through end-2026. Under the base case, year-over-year core PCE will fall to 3.0% in December 2026 and 2.4% by end-2027; accordingly, the report expects cumulative rate cuts of 50 basis points in 2027. It also stresses that if inflation does not ease sufficiently or strengthens again, 2027 rate cuts could be canceled, and hikes may even be needed in an extreme case.
Analysis framework
The report combines CPI, PPI, and PCE nowcasts, decomposing core goods, housing, and energy components. It also monitors effective tariff rates, crude oil inventories and prices, and uses an FRB/US-model-based financial conditions measure to assess the impact of asset-price changes on economic activity.
Methodology notes
Using published CPI and PPI data to forecast PCE inflation
Consumer-price and producer-price components are used to form a tracking assessment of month-over-month and year-over-year headline and core PCE growth for the current month.
Converting changes in multiple asset prices into equivalent changes in the federal funds rate
The indicator incorporates the 10-year Treasury yield, S&P 500 returns, BBB credit spreads, dollar valuation, and oil prices, weighted by their estimated growth elasticities.
Comparing growth, employment, and inflation paths under oil-price, demand, and AI-productivity shocks
Different oil-price and aggregate-demand assumptions are used to assess upside and downside risks to the baseline forecast.
Asset mapping & comparison
Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).
- US TreasuriesDisinflation, no action this year, and potential 2027 rate cuts provide medium-term support, but the near term remains constrained by oil-price and inflation risks.
- Strengths
- Easing core inflation and cooling employment help reduce expectations of further tightening.
- Weaknesses
- PCE remains above target, and the 10-year yield has recently tightened financial conditions.
- Comparison
- Compared with highly valued risk assets, Treasuries are more defensive against unexpected weakening in growth or inflation.
- Risks
- An oil-price shock, sticky inflation, or renewed Fed hikes could all push yields higher.
- US EquitiesFinancial conditions have eased since the July FOMC, with rising equity prices among the main drivers.
- Strengths
- Disinflation and expectations of future rate cuts support valuations and risk appetite.
- Weaknesses
- AI-related demand could raise prices for electronics and software, increasing inflation and rate uncertainty.
- Comparison
- Compared with credit assets, equities benefit more directly from easier financial conditions, but are also more sensitive to changes in growth and valuations.
- Risks
- A surge in oil prices, higher tariffs, a higher-for-longer rate path, and escalating geopolitical conflict.
- Crude OilRenewed escalation in the Middle East has lifted spot and futures oil prices, making oil a key variable in the inflation path.
- Strengths
- Geopolitical risk, falling inventories, and continued declines in the Strategic Petroleum Reserve can support prices.
- Weaknesses
- US domestic crude output is rising, and demand destruction may emerge in a high-price environment.
- Comparison
- Compared with other inflation components, oil prices have a more direct short-term impact on headline inflation and financial conditions.
- Risks
- Conflict de-escalation, supply recovery, or weaker demand due to an economic slowdown.
- US DollarDollar depreciation has been an important source of easier financial conditions since the July FOMC.
- Strengths
- A weaker dollar can ease financial conditions and support economic activity.
- Weaknesses
- Dollar weakness could reverse if inflation risks rise or Treasury yields increase.
- Comparison
- Dollar moves affect a broad range of assets through the financial-conditions channel rather than reflecting only a single inflation component.
- Risks
- Safe-haven demand, upward revisions to rate expectations, and geopolitical conflict could all strengthen the dollar.
Key data
- July Core CPI MoM0.22%Year-over-year growth was 2.5%.
- July Headline CPI MoM0.07%Year-over-year growth was 3.3%.
- July Core PCE Forecast0.23% MoM, 3.27% YoYUpdated based on July PPI data.
- July Headline PCE Forecast0.14% MoM, 3.64% YoYThe PCE-CPI gap is expected to narrow over time.
- End-2026 Core PCE Forecast3.0% YoYBaseline inflation path.
- End-2027 Core PCE Forecast2.4% YoYClose to but still above the 2% target.
- 2027 Policy Rate Forecast50 basis points of cumulative rate cutsA 25-basis-point cut is expected in each of March and June.
- US Effective Tariff Rate6.8% average from March to May 2026Expected to approach 10% by year-end.
- WTI Spot Price$84.77/barrelAs of August 11.
- Brent Spot Price$93.26/barrelAs of August 11.
- Change in Financial Conditions Since the July FOMC31 basis points of easingMainly driven by higher equity prices and dollar depreciation.
Impact & implications
The base case supports lower market pricing of near-term rate hikes and favors risk assets and rate-sensitive assets; however, markets should retain a risk premium for higher oil prices, higher tariffs, and renewed demand acceleration. For fixed income, sustained inflation easing would improve expectations for future rate cuts; if disinflation stalls, yields and the policy-rate path face upside risk.
Risks
- Escalation of the Middle East conflict raises oil prices and generates stronger inflation pressure through energy and transportation costs.
- The effective tariff rate could rise toward 10% by year-end, causing goods prices to fall less than expected.
- AI-related demand could directly raise prices for memory, electronics, and software, or generate second-round inflation through demand expansion.
- Housing inflation may converge toward market-rent trends more slowly than expected.
- If disinflation proves only temporary, the Fed could cancel 2027 rate cuts and even raise rates by 50 to 75 basis points.
What to watch
- Whether subsequent core PCE, core goods prices, and housing rent components continue to decline.
- The impact of oil prices, US-Iran relations, and Middle East developments on energy costs and inflation expectations.
- Developments in effective tariff rates, tariff revenues, and rebate data.
- FOMC minutes' language on inflation risks, data dependence, and the policy reaction function.
- Whether employment, wages, manufacturing surveys, housing starts, and permit data further signal cooling demand.
- Changes in the contributions of Treasury yields, the dollar, equities, and credit spreads to the financial conditions index.