Morgan Stanley expects the Federal Reserve to proceed with cutting interest rates in 2026 despite the recent oil-driven inflation shock, noting that underlying price pressures remain limited and are unlikely to derail the overall downward trend in inflation.
In a recent note, the bank stated that the key variable for policymakers is not headline inflation, which has been driven up by rising energy prices, but rather whether long-term inflation expectations remain stable. So far, those expectations have remained relatively stable, even as short-term inflation measures have risen in response to higher oil prices.
The report highlights that while one-year inflation expectations have risen, this reflects temporary energy-related price pressures rather than a structural shift in inflation dynamics. Longer-term expectations—which the Federal Reserve closely monitors—have remained close to pre-pandemic levels, suggesting that confidence in inflation control remains intact.
Morgan Stanley’s baseline scenario assumes a limited impact of higher oil prices on core inflation, which excludes volatile food and energy components. As a result, the Federal Reserve is likely to overlook the current rise in energy costs, provided that progress in core inflation measures continues.
The bank also noted that financial conditions have tightened considerably since the start of the conflict in the Middle East, with the combined effect of a stronger dollar, higher oil prices, and increased equity risk premiums equivalent to nearly 80 basis points of an interest rate hike. This tightening reduces the need for further policy tightening from the Federal Reserve.
Against this backdrop, Morgan Stanley expects the Federal Reserve to begin easing policy later in 2026, with the possibility of interest rate cuts in the second half of the year as growth slows and inflation gradually declines. The central bank is expected to deliver two 25-basis-point cuts, bringing the policy rate down to a range of 3.00% to 3.25%.
However, the outlook hinges on inflation expectations remaining relatively stable. A sustained rise in long-term expectations could compel the Federal Reserve to keep interest rates high for longer, particularly if energy shocks begin to influence broader price-setting behavior.
Currently, however, Morgan Stanley's view is that the oil shock – while important to markets and consumers – is unlikely to fundamentally change the Federal Reserve's easing trajectory.
