The former "third in command" of the Federal Reserve presented four major reasons to maintain a tight monetary policy stance. Morgan Stanley offered a completely different perspective, arguing that inflation is easing more gently. Deutsche Bank warned that if the Fed chooses to use balance sheet reduction instead of rate hikes, the dollar will continue to weaken.

Source: Jin Ten Data

Recently, a set of objective data seems to have temporarily weakened the urgency for the Federal Reserve to raise interest rates, as gasoline prices have dropped significantly, leading to an overall cooling of inflation, with core inflation excluding food and energy also improving simultaneously; June's job growth has nearly stagnated, and wage growth matches the 2% inflation target, while productivity is improving in the long term.

However, former New York Fed President Dudley pointed out that even if the persuasion for tightening policy decreases in next week’s meeting, four core arguments still support maintaining a tight monetary policy.

First, there is a need for policy adjustment. The unemployment rate is close to the full employment level, but various core inflation indicators are between 2.4% and 3.3%, indicating an imbalance in dual policy objectives, necessitating a restrictive monetary policy correction.

Secondly, the current policy has not produced a tightening effect. The federal funds rate has remained high for nearly four years, and the unemployment rate has stabilized at the full employment range for two consecutive years. If policies are tightened, it should increase unemployment and lower inflation, and a relaxed financial environment also supports this. According to the Federal Reserve's financial conditions index, the current environment could boost GDP by more than 1 percentage point in a year, with stimulus intensity reaching levels seen in the zero interest rate phase of early 2022.

Thirdly, the expansion of the AI industry continues to drive demand, raising prices for electricity and chips, which temporarily amplifies inflationary pressures.

Fourthly, the Federal Reserve's credibility faces risks of erosion. Inflation has been above the 2% target for five consecutive years, and if actions are delayed, the market may question whether Waller’s strong statements lack substantial backing; the cost of long-term inflation exceeding targets is higher compared to the losses caused by excessive tightening.

The market currently anticipates that the FOMC will maintain interest rates next week, but Dudley believes that by this autumn, the pressure to raise rates will become evident.

Morgan Stanley provided a completely opposite assessment, with its chief U.S. economist Michael Gapen suggesting that the pace of declining inflation is milder, predicting that the Federal Reserve will remain inactive throughout the year, with potential rate cuts only occurring after inflation retreats in 2027. The divergence stems from the bank's more optimistic outlook on inflation.

Multiple factors support Morgan Stanley’s deferment of its rate hike judgment: the tariff transmission to end consumer prices is nearing completion, and rental inflation continues to ease; geopolitical tensions in Iran are calming, with Brent crude oil falling below $70 per barrel at the end of June, and the institution expects oil prices to remain at $70 by the end of 2027; June's non-farm payrolls increased by 57,000, far below the expected 115,000, and the employment data for the previous two months has been revised down by 74,000, indicating a cooling demand for labor.

The American rate strategist Martin Tobias from the institution constructed a financial conditions index that includes 12 market indicators, showing that since the outbreak of the Iran conflict, the market's self-imposed tightening equates to four 25 basis point rate hikes, and forward rates have absorbed the inflation risk, meaning the Fed does not need to engage in further tightening based on lagging data.

Morgan Stanley also predicts that as Waller significantly reduces forward guidance, the impact of inflation and employment data on market expectations will amplify, leading to increased volatility in short-term rates, highlighting the value of mid-to-short duration bond allocations, while duration risk is lower than that of long bonds.

Deutsche Bank's head of foreign exchange research, George Saravelos, mentioned another method for the Fed to tighten policy—reducing its balance sheet. The institution stated that if the Federal Reserve opts for balance sheet reduction instead of rate hikes to implement tightening, the dollar will continue to weaken.

The current Federal Reserve's balance sheet stands at $6.7 trillion, significantly shrinking from its peak of $9 trillion in 2022. He referenced the Bank of Japan's balance sheet reduction, noting that accelerating sell-offs of government bonds did not bolster the yen, which has fallen to a forty-year low, demonstrating that a balance sheet reduction without rising short-term rates fails to benefit the domestic currency. At the same time, Saravelos pointed out that balance sheet reduction would conflict with the U.S. demand to keep long bond rates low.

In fact, in Saravelos's view, the Federal Reserve's Treasury holdings are not abnormal, and balance sheet reduction is not an effective tool for controlling inflation. However, if the Federal Reserve decides to shift its focus from rate hikes to its balance sheet, it would undoubtedly signal bad news for the dollar.