Fed Expected to Hold Steady This Week; Morgan Stanley Warns: Future Rate Hikes of 75 to 100 Basis Points Still Possible

The Federal Reserve will announce its October interest rate decision on Wednesday local time (2 a.m. Beijing time Thursday), and the market widely expects the Fed to keep rates unchanged, after a 25-basis-point hike at its previous meeting. Morgan Stanley Chief U.S. Economist Michael Gapen agrees with the market's judgment. He said the Fed will hold steady in October, but the market should still expect policy rates to rise afterward. Gapen said that even if the Fed keeps rates unchanged this month, "the Fed is far from out of the woods." How can the Fed justify keeping rates unchanged? Gapen believes the Fed will take a wait-and-see approach, saying it will observe underlying trends to assess the eventual direction of policy. "So I think the balance right now is that they hold rates steady," but expect future policy rates to move higher. According to data from the CME FedWatch tool, the market sees an 88.9% probability that the Fed will keep rates unchanged this week, up sharply from 35.8% a month earlier; meanwhile, the data show an 81.6% probability of a rate hike of up to 50 basis points. Gapen believes the Fed may argue that it will judge for itself whether the tightening of financial conditions is sufficient, and then decide its policy path accordingly. "One reason against raising rates at every consecutive meeting is that it could lead to excessive tightening of financial conditions," he said. However, he added that risks exist whichever path the Fed takes, but a "more gradual pace" is more likely. Market can absorb up to 100 basis points of rate hikes The economist also believes that the Middle East war and rising oil prices will pose risks to inflation, adding that Morgan Stanley is "incorporating some of the impact into next year's inflation forecast," and that the Federal Open Market Committee (FOMC) may also take this into account. The bigger question is whether the Fed is willing to raise rates every other meeting and assess based on the latest data. Gapen added that energy markets may determine the direction of policy. "I think the economy can withstand a total of 75 to 100 basis points of rate hikes without causing huge concerns about yields," Gapen said. But he warned that if the Fed needs to raise rates six to seven times in total to return to 2023 levels, that could trigger some concerns. As of press time, Nasdaq futures and S&P 500 futures were slightly lower, while Dow futures were up 0.16%.