Morgan Stanley believes that last week's interest rate hike by the Fed is merely a "policy adjustment," and Warsh's real trump card against inflation lies in "balance sheet" reform rather than solely relying on interest rate tools. Once the balance sheet reduction plan is implemented, the necessity for aggressive interest rate hikes will significantly decrease, and the final degree of tightening will likely fall within the lower end of market expectations.

Written by: Dong Jing, Wall Street View

Last week, the Fed announced an interest rate hike of 25 basis points, marking its first increase in three years, with the market having fully priced in, and even expected more. Morgan Stanley believes that the current focus is not on the interest rate hike itself, but on the logic behind it and the future path of inflation.

Seth Carpenter, Chief Global Economist at Morgan Stanley, pointed out in the latest report: the significance of this rate hike is not in "what happened," but in "why it happened" and "where it will go next."

The report states that although the Fed took action to raise interest rates due to slow inflation decline and rising energy prices, it resembles more of a "policy adjustment" to maintain the disinflation process rather than initiating a brand new tightening cycle.

Fed Chairman Warsh's policy core revolves around the "balance sheet" rather than just interest rate tools. Once the asset and liability reform plan from his working group is launched, the necessity for aggressive rate hikes will greatly diminish, and the final degree of policy tightening is likely to fall within the lower end of market expectations.

Inflation cooling less than expected, energy prices reshape rate hike motivation

Last week, the Fed raised the policy rate by 25 basis points. Previously, Morgan Stanley had anticipated that, since inflation was moving in the right direction and assuming Fed Chairman Warsh preferred not to raise rates as much as possible, the Fed would likely remain on hold.

However, the reality broke this assumption. Morgan Stanley noted in the report that the key indicator mentioned by Warsh at the Jackson Hole meeting and the September press conference—the six-month inflation trend—while declining, is clearly not fast enough for the Federal Open Market Committee (FOMC).

Additionally, the renewed surge in energy prices brings extra complexity. Due to supply disruptions and the return of risk premiums, oil prices have not moderated as expected. Faced with a painfully slow disinflation process and clear upward risks in energy prices, the FOMC ultimately decided to take action.

Committee's will dominates, dot plot releases "directional" signal

Morgan Stanley pointed out that although Warsh made clear in his public comments before his appointment that he believes the reason inflation is above target is due to the Fed's balance sheet rather than interest rates, the traditional interest rate tools of the FOMC currently obviously dominate. Policies are determined by FOMC votes, and the new chair has significant influence but cannot immediately or completely change this decision-making process.

As early as the June dot plot, a considerable number of committee members leaned towards further tightening, with three even voting against the rate hike in July. Therefore, the rate hike in September was not only Warsh's individual decision but also a reflection of the majority position within the committee—a significant number of members are reluctant to declare victory in the fight against inflation too early.

Morgan Stanley warns against over-interpreting the dot plot. Currently, the median expectation only shows one more rate hike, retaining the option for a second hike. The dot plot is best viewed as a "directional signal" rather than a clear prediction: if inflation does not improve sufficiently, the Fed is willing to tighten further. Moreover, the distinction between voting and non-voting members next year is crucial, as most voting members may wish to push rates to higher levels.

Policy adjustment rather than framework change, market may overestimate the rate hike magnitude

Is the September rate hike the beginning of a new tightening cycle, or a correction within the current framework?

Morgan Stanley believes it is the latter. The Fed's statement indicates that this action aims to bring inflation back to target in a "more timely" manner. The direction of inflation is correct; the Fed just hopes for a slightly faster pace. This does not declare that the previous policies were fundamentally wrong, but merely an adjustment in degree.

This leads to the "key question" proposed by Morgan Stanley: how does Warsh intend to achieve price stability? Warsh has always emphasized that the balance sheet is the core factor driving inflation, yet the balance sheet was not mentioned at all in the September press conference. This contradiction strengthens one possibility:

The number of rate hikes expected by the market may exceed the actual number this Fed will deliver. Once Warsh's working group completes its tasks, balance sheet reform could directly reduce the necessity for aggressive rate hike measures.

Overall, the Fed's increased concerns about inflation and willingness to take action seem more intended to recalibrate to maintain the disinflation process (what the market usually refers to as the unwinding of last year's "insurance rate cuts"). The U.S. economy can withstand these rate hikes.

Morgan Stanley believes that if the disinflation process continues as expected, the degree of policy tightening sought by the Fed will become clearer and is likely to fall within the lower bounds of market expectations.