Morgan Stanley predicts that at the Jackson Hole Federal Reserve meeting next week, Powell will "hawkish" and resist market expectations of a rate cut.

Just as the global market almost saw the Federal Reserve's interest rate cut in September as a certainty, Wall Street's top investment bank, Morgan Stanley, issued a completely opposite and influential warning. The report pointed directly at a "bad news" that was widely overlooked by the market a more sticky service sector inflation than expected, which is forcing Federal Reserve Chairman Powell to "hawk" at Jackson Hole. Morgan Stanley predicts that at next week's highly anticipated Jackson Hole global central bank annual meeting, the expected "green light" for interest rate cuts may not be given. Instead, there will be a strong pushback against the market's aggressive expectations with a hawkish stance. 93% certainty: How was the "one-way street" of rate cuts paved in the market? The logic of the financial market has seemed exceptionally clear and unified in the past month. According to Morgan Stanley's latest report released on August 15, after the key inflation data was released, traders in the market still lock the probability of a 25 basis point rate cut in September at a high of 93%, believing that the rate cut is almost a done deal. This enthusiastic consensus mainly stems from the weak July employment report. The report not only showed a slowdown in new job additions, but also included a significant downward revision of historical data by up to 258,000. This led investors to quickly conclude that the cooling of the labor market was greater than expected, and the economic downside risks could not be ignored. The narrative of the market thus formed: in the face of the risk of the employment engine possibly stalling, as long as inflation data does not show catastrophic spikes, it would not be enough to stop the Federal Reserve from opening the path for precautionary rate cuts. The report described investors' mentality in this way: "They saw the CPI data for July and concluded that it was not enough to counter the downside risks facing the labor market." Thus, a one-way street towards a rate cut in September seems to have been paved, and the market has been running along this road. Core warning: The real problem is service inflation, not tariffs However, in the collective optimism of the market, analysts at Morgan Stanley found hidden risks. They pointed out that the market may have focused on the wrong place. The real trouble is not coming from external tariffs, but from internal, more stubborn service sector inflation. "This is an unexpected surprise for us," the report admitted, "The strength of core inflation is being driven by the service sector rather than goods." Data shows that the year-on-year growth rate of core CPI in July has quietly accelerated from 2.9% to 3.1%. Deeper data reveals that service prices excluding energy rose by 0.4% month-on-month, while the market's previous highly alert, tariff-affected goods prices only increased by 0.2%. Why is this seen as "bad news" by Morgan Stanley? The report provided a profound explanation: "The strength of service sector inflation may worsen the (policy) outlook because it is more sticky." Unlike the volatile commodity prices affected by global supply chains and tariffs, service sector inflation is mainly driven by domestic factors such as labor costs and rent. Once a rising trend is formed, it is difficult to dissipate on its own in the short term. The report further emphasized, "The Federal Reserve finds it more difficult to manage strong service sector inflation." Although analysts admitted that the jump in service inflation in July was partly exaggerated by "volatile categories such as airfare and dental services," a more warning signal comes from the Producer Price Index (PPI) service prices in the final demand category rose significantly by 1.1% in July, indicating that the future terminal inflation pressure cannot be underestimated. Putting a brake on the market's feverish expectations This subtle but crucial change in the inflation structure has put Federal Reserve Chairman Powell in an extremely difficult position. His biggest fear right now is not the economic data itself, but being "kidnapped" by the market's feverish expectations before the crucial decision point arrives. Morgan Stanley repeatedly emphasized in the report that the Federal Reserve's core demand is to "retain optionality," especially before the complete employment and inflation data for August are released, to avoid being pushed into a corner by the market. The risk of this situation is very high. The report bluntly pointed out, "If the Federal Reserve allows the market to price in a rate cut in an almost certain way, then avoiding a rate cut in September will become very difficult." With the market already pricing in a 23 basis point rate cut, "not cutting rates would be equivalent to a rate hike," which could trigger severe financial market turmoil, a situation the Federal Reserve is eager to avoid. Therefore, Powell must take action to put a brake on the market's feverish expectations. What supports him to take a hawkish stance is the internal division within the Federal Reserve, which is far from unified and can even be described as increasingly differentiated. At the last monetary policy meeting, Governors Waller and Bowman voted against the decision. Recently, several hawkish officials, including St. Louis Fed President Mester and Kansas City Fed President Schmid, have openly expressed concerns about the upward risks in inflation. The most convincing signal comes from former "dove" and current Chicago Fed President Goolsbee. In a speech on August 13, he unexpectedly turned hawkish, not only clearly stating that the resilience of service sector inflation is "bad news," but also describing the labor market as having cooled from "very hot to 'sustainable full employment'." The implication of his remarks is that his concerns about the labor market have significantly decreased, while his vigilance against the sustainability of inflation is sharply rising. When even the former "doves" start ringing the inflation alarm bells, the market's certainty about a rate cut becomes particularly fragile. Conclusion: A "expectation management" storm to allow the Federal Reserve to reclaim policy initiative Taking everything into consideration, next week's Jackson Hole annual meeting may be a crucial "expectation management" storm personally directed by Powell. Morgan Stanley predicts that Powell's speech will send a clear signal: it is too early to predict the ultimate impact of tariffs, and inflation issues are more pressing and challenging than employment issues. He will not completely close the door to a rate cut in September, but his core task is to break the market's "inevitable rate cut" narrative, allowing the Federal Reserve to reclaim policy initiative and wait for more data to be released. For global investors, it is important to be cautious and prepared for the potentially severe market corrections that may come from "expectation gaps." The message that Powell is likely to send out is - everyone needs to be patient, "let the bullets fly a little longer" before seeing the next crucial data. The article is from "Wall Street Seen", author: Gao Zhimou, GMTEight editor: Chen Qiuda