Morgan Stanley expects the Fed to stay on hold in July and patiently await more inflation and labor data

Overview

This is a Morgan Stanley U.S. Economics Weekly report focused on whether the July FOMC will continue to remain patient. The report judges that recent labor and inflation data have strengthened the case for the Fed to pause: job growth has slowed, historical data have been revised down, the unemployment rate is broadly stable, and on inflation, softer CPI together with tariff pass-through, energy prices, and housing inflation all support disinflation. In the base case, the Fed keeps the target range unchanged at 3.50%-3.75% in July and remains on hold for the rest of 2026.

Core views

First, the Fed is more likely to wait and see in the near term rather than resume rate hikes. Second, improving inflation has bought the Fed time, and the report expects annualized monthly core inflation in the second half to be close to 2.0%. Third, tariffs are not facing a cliff-like decline; instead, they are shifting from the temporary Section 122 mechanism to a combined Section 301 and 232 framework, with the statutory effective tariff rate likely returning to about 9%-10% by year-end. Fourth, the Middle East conflict and rising oil prices could still push up rate risks through inflation expectations, second-round effects on core inflation, and tighter financial conditions. Fifth, 2Q real GDP tracking is 1.7%, while consumption and private domestic final demand still show some resilience.

Analysis framework

The report combines macro data tracking, policy-rule analysis, and a financial conditions model: it uses employment, CPI, PCE, GDP tracking, and the high-frequency economic calendar to assess the Fed’s reaction function; it uses legal frameworks such as Sections 301, 232, and 122 to assess the continuity of the tariff regime; and it uses a financial conditions index under the FRB/US framework to measure the equivalent impact of rates, the dollar, oil prices, equities, and credit spreads on future economic activity.

Methodology notes

• Monetary Policy AnalysisFOMC reaction function assessment

  Assess whether the Fed needs to adjust policy rates based on employment, inflation, and the distribution of risks.

  The report believes that reduced concerns about labor overheating, softer CPI, and underlying disinflation give the Committee reason to keep waiting; if this judgment is wrong, the most likely reason would be that the Fed’s reaction function becomes more hawkish.

• Financial Conditions ModelFRB/US-based financial conditions index

  Convert changes in the 10-year Treasury yield, S&P 500 returns, BBB credit spreads, the dollar, and oil prices into equivalent changes in the federal funds rate.

  This index is used to estimate the impact of asset price changes on future economic activity; the report says financial conditions have tightened by the equivalent of about a 67bp rise in the federal funds rate since the Middle East conflict began.

• Trade Policy AnalysisEffective tariff rate tracking

  Estimate the effective tariff rate on U.S. imports by combining tariff revenue, rebates, import composition, and changes in legal authorization.

  The report estimates that the average effective tariff rate from March to May 2026 was 6.8%, about 6.9% in May, and that the statutory effective tariff rate will approach about 9%-10% by year-end.

• Growth Tracking2Q GDP tracking

  Update quarterly GDP component forecasts based on released data.

  The report keeps 2Q real GDP tracking at 1.7% and compares it with the Atlanta Fed GDPNow estimate, which has the same headline total but a different component structure.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• U.S. policy rates

  Core subject of research

  Strengths

  Employment and inflation data support the Fed staying patient, reducing the near-term need for rate hikes.

  Weaknesses

  Oil prices, tariffs, and changes in the reaction function could push policy-rate expectations higher again.

  Comparison

  Compared with a scenario requiring immediate rate hikes, the report is more inclined toward keeping rates unchanged.

  Risks

  If the Middle East situation escalates or inflation reaccelerates, the policy-rate path could be revised upward.

• U.S. Treasuries

  Key variable in financial conditions

  Strengths

  If the Fed stays on hold and inflation continues to ease, upward pressure on yields may be limited.

  Weaknesses

  The report says rising 10-year Treasury yields have been an important source of recent tightening in financial conditions.

  Comparison

  Compared with the easing from dollar weakness earlier in the year, long-end rates and the dollar have recently pushed conditions tighter.

  Risks

  Higher oil prices, a hawkish Fed, or a higher neutral rate could push yields up.

• U.S. dollar

  Key variable in financial conditions

  Strengths

  A stronger dollar reflects safe-haven or rate-differential effects and can partly restrain imported inflation.

  Weaknesses

  The report says the reversal of dollar weakness has been one of the main drivers of tighter financial conditions.

  Comparison

  Dollar weakness earlier in the year had eased conditions, but later appreciation reversed that effect.

  Risks

  If the dollar continues to strengthen, it could weigh on growth and affect cross-asset risk appetite.

• Crude oil

  Source of inflation risk

  Strengths

  If oil prices fall back, that would support the report’s baseline disinflation scenario.

  Weaknesses

  After the escalation of the Middle East conflict, spot and futures oil prices rose notably, reviving inflation concerns.

  Comparison

  After the MOU, oil prices once came close to pre-conflict levels, but the latest escalation has brought oil-price risk back.

  Risks

  Persistently high oil prices could lift core inflation and policy rates through second-round effects.

• U.S. equities and credit spreads

  Offset within financial conditions

  Strengths

  The report says strong equity markets and credit spread performance have offset part of the overall tightening in financial conditions.

  Weaknesses

  If rates and the dollar continue to rise, support from risk assets may weaken.

  Comparison

  Compared with the tightening impact from oil prices, the dollar, and Treasury yields, equity and credit markets have provided some buffer.

  Risks

  An upward revision to the policy-rate path or a downgrade to growth expectations could trigger a repricing of risk assets.

Key data

• July FOMC rate expectation3.50%-3.75%The report expects the federal funds target range to remain unchanged in July.
• Policy path for the rest of the yearUnchangedThe base case is that the Fed remains on hold for the rest of 2026.
• June nonfarm payrolls57kThe report believes job growth has slowed and is close to the estimated breakeven job growth of about 50k per month.
• Unemployment rate4.2%Labor market risks are described as roughly balanced.
• Average hourly earnings y/y3.5% y/yWage growth no longer shows clear overheating.
• Underlying disinflation room60-70bpFrom disinflation that may still be in the pipeline after tariff pass-through ends.
• Year-end statutory effective tariff rate baselineabout 9%-10%After Section 122 expires, the Sections 301 and 232 frameworks are expected to take over.
• Effective tariff rate from March to May 20266.8%The report says the three-month average based on trade data was 6.8%.
• Effective tariff rate in May 2026about 6.9%Estimated based on May trade data.
• 2Q real GDP tracking1.7% q/q saarConsistent with the Atlanta Fed’s headline tracking, but with a different component structure.
• 2Q consumption forecast2.4%The report says consumption still supports growth.
• 2Q nonresidential private fixed investment forecast5.0%Reflects resilient business investment.
• Tightening in financial conditions since the Middle East conflictabout 67bpConverted into an equivalent federal funds rate change using the FRB/US financial conditions model.
• Tightening in financial conditions since the June FOMCnearly 50bpMainly driven by higher 10-year Treasury yields and dollar appreciation.
• SPR inventoryabout 311 million barrelsThe report says this is the lowest level since April 1984.

Impact & implications

For markets, the report’s base-case implication is that pressure for short-end rate hikes has eased and the soft-landing narrative has gained support from the data, but risks have not disappeared. If oil prices continue to rise, the dollar and long-end Treasury yields further tighten financial conditions, or the Fed Chair/Committee reaction function turns more hawkish, the yield curve and risk assets could still reprice to a higher policy-rate path. The tariff framework’s shift from a temporary mechanism to a more rules-based but still uncertain combination of Sections 301 and 232 also means that corporate costs, import composition, and inflation pass-through still need close monitoring.

Risks

• Oil prices remain elevated due to an escalation in the Middle East conflict and push up core inflation through second-round effects.
• The Fed may judge that the distribution of risks to its dual mandate requires a tighter policy stance.
• AI-related capital spending may raise the neutral rate, making the current policy stance insufficiently restrictive.
• The Fed Chair or Committee reaction function may be more hawkish than the report assumes.
• The timing, scope, exemptions, and interactions of Sections 301 and 232 tariff measures remain uncertain.
• Import composition, bilateral agreements, and the timing of rebates could cause actual tariff collection to diverge from statutory rates.
• June trade data may alter the component-level assessment of the trade drag and equipment investment in 2Q GDP.

What to watch

• Whether the July FOMC statement and press conference retain language such as 'patient'.
• Whether subsequent CPI and PCE data continue to show cooling core inflation.
• Oil prices, SPR inventories, developments in the Middle East conflict, and their impact on inflation expectations.
• The scope, tariff rates, exemptions, and effective dates of the final Section 301 and 232 measures.
• Revisions to 2Q GDP tracking from June trade and capital goods data.
• Changes in financial conditions driven by the 10-year Treasury yield, the dollar, the S&P 500, BBB credit spreads, and oil prices.
• Whether University of Michigan inflation expectations are affected by rising oil prices.