According to the latest research report from Morgan Stanley, the Federal Reserve enacted a "dovish pause" at its January FOMC meeting. Despite holding rates steady, the signals released by the Fed indicate a shift in the future path of rate cuts, no longer relying solely on labor market weakness but depending more on the performance of receding inflation data.
On January 29, Morgan Stanley's report pointed out that Fed Chair Jerome Powell emphasized the strong performance of economic data and "some signs of stabilization" emerging in the labor market during the meeting. Most crucially, the Fed maintained confidence in its judgment that tariff-induced inflation would be "transitory." Powell stated that the downside risks to employment, which previously served as a rationale for "risk management" rate cuts, have diminished, while upside risks to inflation have also decreased.
This implies the Fed is in no rush to ease policy further. Morgan Stanley's team of economists believes the committee currently leans towards lowering the policy rate only after seeing clearer signs of inflation deceleration. Based on expectations that disinflation evidence may appear later this year, the firm maintains its outlook for the Fed to cut rates in June and September.
Although Powell did not make explicit commitments regarding the specific drivers of future rate cuts, Morgan Stanley interprets that the Fed still holds an easing bias and views the current policy stance as "well-positioned." Provided the economic outlook develops as the Fed expects, the policy rate will be gradually lowered once evidence of disinflation is established, with the current rate level seen at the upper end of the neutral range, suitable for guiding inflation downward.
Economic Resilience and an Inflation-Driven Policy Shift FOMC members showed greater consensus on the economic outlook at this meeting. Powell noted that the economic outlook is stronger now compared to the December meeting, maintaining "robust" momentum heading into 2026. Factors supporting this view include resilient consumer spending, expanding business investment, anticipated fiscal support, favorable financial conditions, and sustained AI-related capital expenditure. The housing market was identified as the sole area of weakness.
With the downside risks to employment having diminished, the logic for future rate cuts has fundamentally shifted. Morgan Stanley analysis suggests that if the economic outlook aligns with expectations, future cuts will be "inflation-based." Since evidence of disinflation may not emerge until the second half of the year, the Fed will remain patient. Powell reiterated a "meeting-by-meeting" decision-making stance during the press conference, hinting that with solid economic growth, a largely stable unemployment rate, and slightly elevated inflation, the Fed feels no urgency to act.
Risk Scenario: If Disinflation Stalls, No Cuts for the Full Year Although the base case calls for two rate cuts within the year, Morgan Stanley also highlighted the upside risk of "no rate cuts for the full year of 2026." If the economy experiences what the firm describes as an "animal spirits" inflationary scenario, where fiscal stimulus exceeds expectations and the policy backdrop triggers an earlier, stronger acceleration in demand, inflation might struggle to decelerate.
In such a scenario, with tariff pressures expected to subside after Q1 2026, if demand-side forces are so strong that they hinder the decline in inflation and monthly inflation data show no substantive slowdown, the Fed might choose to remain on hold until the end of the year, rather than further easing policy via rate cuts to achieve normalization.
The Productivity Puzzle and Data Noise Regarding the relationship between productivity and AI, Powell expressed cautious optimism. He suggested that current productivity growth is higher than fundamentals would indicate but did not directly attribute this to AI. Instead, he believes solid economic growth accompanied by a sharp slowdown in hiring is likely the primary cause. Powell noted that if the economy remains robust, it will generate some labor demand, thereby restraining productivity growth. Morgan Stanley added that fluctuations in trade and inventory data may also be playing a role, expecting productivity growth to potentially slow in future quarters as these factors fade.
On data quality, Powell was more optimistic in his assessment of the labor market and inflation, indicating the committee is extracting signals from the recent noisier data. Regarding data distortions, Powell believes they no longer pose a substantial obstacle, amounting merely to "tweaks here and there."
Market Strategy: Stay Neutral, Focus on Swap Spreads Based on the current policy outlook, Morgan Stanley's interest rate strategist Matthew Hornbach and his team recommend investors maintain a neutral stance on US Treasury duration and the yield curve, while continuing to be long 2-year UST SOFR swap spreads. Current market pricing indicates investors expect two more 25-basis-point cuts, which aligns closely with the firm's economists' probability-weighted forecast.
In the foreign exchange market, Morgan Stanley continues to forecast a weaker US dollar. However, given that market pricing already largely reflects the Fed's policy outlook, Fed policy is unlikely to be the primary driver of dollar depreciation. Market focus is expected to shift more towards international monetary policies and associated intervention risks.
For agency MBS (mortgage-backed securities), Morgan Stanley strategist Jay Bacow maintains a neutral stance. Although a low-volatility environment is favorable for MBS, index OAS (option-adjusted spreads) are near their tightest levels in recent years, and housing policy uncertainty remains. Furthermore, the Fed confirmed it will continue to increase SOMA portfolio securities holdings by purchasing Treasury bills and reinvesting all principal payments from agency MBS into Treasury bills, keeping balance sheet policy unchanged.