Tariff pass-through and peak inflation timing

Our Global Head of Macro Strategy Matthew Hornbach and Chief U.S. Economist Michael Gapen discuss the Fed’s path as inflation remains above its target and the labor market continues cooling.

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Matthew Hornbach: Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy. 

Michael Gapen: And I'm Michael Gapen, Morgan Stanley's Chief U.S. Economist. 

Matthew Hornbach: Yesterday, the FOMC meeting delivered another quarter percentage point rate cut. Today we're here to discuss what happens next.

It's Thursday, December 11th at 8:30 AM in New York. 

So, Mike, once again, the Fed cut rates by 25 basis points. That outcome was not a surprise, and the markets reacted positively. But there were some surprises. A bit of a divided FOMC, if you will. How did things play out during the meeting and what are some important takeaways to keep in mind? 

Michael Gapen: Yeah, well certainly Matt, it is a divided committee. I think that's clear. 

I think one key takeaway for me is the idea that the Fed is done with risk management rate cuts, and now we're back to data dependent. So, what does that mean? I mean, a risk management rate cut isn't necessarily about the data you have in hand and the data you see; it's your view about the distribution of risks around that. 

So, in some ways, you're not data dependent when you're making those cuts. Now, I think the challenge at this press conference for Powell was to say, ‘Well, now things are different.’ And it was a nuance in the sense that cuts from here, if and when they come, will be data dependent. 

But I think at the same time he did not want to communicate that the bar for those rate cuts were exceptionally high. 

But I think he threaded the needle quite well in transitioning from risk management cuts, which aren't data dependent to an outlook, which is now more data dependent. And I thought he did that artfully well. So, for me, that's the big key. 

Secondarily I'd add a takeaway for me was he seems fairly confident that inflation will be coming down, and I think he still believes the labor market is cooling. The blend of that came across as a bit dovish to me. And then the third thing I would add is he fairly explicitly ruled out the risk of rate hikes. So, I think the combination of those three things: data dependence, still concerns about cooling in the labor market, and chopping off the upper half of the rate path distribution – those were kind of the key takeaways from my point. 

Matthew Hornbach: So, Mike, with respect to the labor market, Chair Powell did address it in a couple of different ways. But one of the ways that stood out to my ears was how he described some technical factors that people are well aware of – that could mean the economy is actually shedding jobs to the tune of about 20,000 per month. 

I was wondering if you could just briefly address what those factors – that are supposedly so well known – might be. 

Michael Gapen: Sure. So, obviously the data that gets released, there are the initial releases and then there are revisions. And in the labor market, there are what are called annual benchmark revisions. 

So, the BLS released a preliminary estimate of that benchmark revision several months ago, and if you apply that initial estimate, it would suggest that job growth in 2025 could be about 60,000 jobs per month, less than has already been reported. 

But at the same time, we know immigration controls are slowing growth in the labor force. So, this is what Powell is calling the really curious balance. How can you have employment growth basically zero, maybe even negative, after these revisions come in – and the unemployment rate relatively stable. Yes, it's gone up a few tenths, but not like you would normally expect that rise would be if we were shedding jobs. So that to me is why he… You know; the technical factors about revisions and things that lead them to be, I think, very unsure about where the labor market is; and lean in the direction of thinking lower rates are better to manage those risks than where they were six months ago. 

Matthew Hornbach: One of the points that you raised in your opening explanation of the meeting was about inflation. And Chair Powell mentioned an expectation that the inflation related to tariffs would be peaking in the first quarter of the year. That sounded very familiar to me because I believe that's your expectation as well. 

I'm curious. How are you looking at tariffs and the inflation related to tariffs today? And do you agree with Chair Powell still? 

Michael Gapen: We do. Our modeling of the tariff pass through and our conversations with clients and firms and what we hear on corporate earnings calls suggests that this is a long process. Meaning tariffs go in place, prices don't go up the next month. Firms make pricing decisions that take time to implement. So, we agree that the tariff pass through story will extend into 2026 and likely through the end of the first quarter. And if that's true, then goods prices should continue to move higher. The year-on-year rate of inflation should move higher, peaking at 3 percent or a little above in the first quarter of the year. 

And then tat effect should we think be over, which would open the door for overall inflation to start coming back down. 

So, I will use the dreaded T-word. We think ultimately inflation from tariffs will be transitory. And I agree with the Chair's timeline; inflation should peak in the first quarter of the year and then start to trend down. That said, we think inflation will be above the Fed's 2 percent target into 2027, and this is the cost of providing insurance to the labor market. 

Matthew Hornbach: So finally, all things considered, what is your outlook for Fed policy in 2026? 

Michael Gapen: Yeah, and the key here, Matt, is that exactly what you just implied about tariffs and inflation still going on into 2026, right? Because what we know is while firms are gauging exactly where they should be pricing, they've been offsetting tariffs through lower demand for labor. 

So, we think the Fed will be cutting again in January. We have three months of employment data that come across two employment reports between now and the January meeting. We think they will show continued cooling in the labor market. And then we have a second cut next year in in April. So, while tariffs are getting passed through, we think the labor market will continue to cool. 

And this Fed will be biased to cutting rates to provide support to the labor market in the process. That would mean the federal funds rate gets to 3 – 3.25 percent in the second quarter of 2026, where we think it'll stay.

So Matt, I'd like to ask you a question. What I noticed was the rate market backed up going into the meeting, despite the fact that market participants were projecting a cut. And then the rate market rallied, in my view, significantly during the meeting and right after. What do you think was happening there? 

Matthew Hornbach: So, there's a phenomenon that happens in all markets where investors often speculate on a potential outcome. And if the outcome is then delivered, the follow-on price action is underwhelming. That is colloquially known as buying the rumor and selling the fact. So, I think going into this meeting kind of in line with your expectations, investors were forming very similar expectations about how the FOMC statement itself would change and the implications that that might have for the future of Fed policy. 

When that hawkish cut was delivered almost exactly as you had expected, Mike, I think, investors started thinking about the future in a slightly different way. Now that their expectations were met with the meeting outcome, they started to consider, the data that is forthcoming. And whenever, officials at the Fed talk about data in the way that Chair Powell spoke about the data – and by which I mean labeled the labor market as potentially losing jobs at the moment, and labeling inflation as transitory, that we'd be past the peak of tariff related inflation after the first quarter of the year. 

Investors can kind of look at those factors and extrapolate going forward, what that may mean for Fed policy in the first half of 2026. So, I think similar to your expectations for policy after this meeting, investors probably became a bit more confident in your outlook for Fed policy that we would see additional rate cuts in the first half of next year. 

And then, of course, after the April meeting, the baton will be passed to the next Fed chair, and I think investors are considering what policy might look like under that new regime at the Fed. And on the margin, the view is that the next Fed chair would be more likely than not to continue the process of lowering policy rates. So, I think all of those factors played into the post press conference, and even during the press conference reaction. 

Michael Gapen: Okay Matt, one last question, if I may. How did the events of the FOMC this week and the market reaction, how does that dovetail with how you're thinking about longer term rates, in particular where you see 10-year yields going? And the dollar? 

Matthew Hornbach: So, 10-year yields are relatively close to 4 percent at this juncture, and we expect them to drift modestly lower in the first half of 2026, as the Fed continues this process of lowering the policy rate. 

One point that's very important to make here is that the longer-term Treasury yields today are now sitting well above the Fed's policy rate, and that hasn't been the case for many, many years now. A lot of investors with whom we speak think that longer term yields can head a lot higher from here. But we're skeptical – because the higher that those yields go relative to the Fed's policy rate, the more attractive those bonds become for other investors to buy. So, we don't expect a big increase in longer term interest rates. Unlike some investors, we are expecting interest rates in the long end to remain relatively stable with a downward bias.

On the dollar, similarly, we have the dollar continuing its depreciation trend, which it began in January of 2025, earlier this year. We expect that depreciation trend to continue in the first half of 2026 before – similar to the interest rate path – we see a little bit of dollar strength in the second half of the year. 

And so, you know this being the last FOMC meeting of the year, Mike, I guess we're going to have to take a wait and see approach until the FOMC reconvenes in the new year. Thanks a lot for taking the time to talk about the Fed with me this year. 

Michael Gapen: Great speaking with you Matt. See you in 2026. 

Matthew Hornbach: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.