Morgan Stanley expects the Federal Reserve to proceed with interest rate cuts in 2026 despite the recent oil-driven inflation shock, arguing that underlying price pressures remain contained and unlikely to derail the broader disinflation trend.
Get premium news and insight by upgrading to InvestingPro In a recent note, the bank said the key variable for policymakers is not headline inflation, which has been pushed higher by energy prices, but whether long-term inflation expectations remain anchored. So far, those expectations have stayed relatively stable, even as short-term inflation gauges have risen in response to higher oil prices.
The report highlights that while one-year inflation expectations have picked up, this reflects temporary energy-related price pressures rather than a structural shift in inflation dynamics. Long-run expectations—closely watched by the Fed—have remained near pre-pandemic levels, suggesting that credibility around inflation control is still intact.
Morgan Stanley’s base case assumes limited pass-through from higher oil prices into core inflation, which excludes volatile food and energy components. As a result, the Fed is likely to “look through” the current spike in energy costs, provided there is continued progress in underlying inflation measures.
The bank also noted that financial conditions have already tightened significantly since the onset of the Middle East conflict, with the combined impact of a stronger dollar, higher oil prices and rising equity risk premiums equivalent to roughly an 80 basis point rate hike. This tightening reduces the need for additional policy restraint from the Fed.
Against this backdrop, Morgan Stanley expects the Fed to begin easing policy later in 2026, with rate cuts likely in the second half of the year as growth moderates and inflation gradually cools. The central bank is projected to deliver two 25-basis-point cuts, bringing the policy rate down toward a 3.0%–3.25% range.
Still, the outlook hinges on inflation expectations remaining well-anchored. A sustained rise in long-term expectations could force the Fed to keep rates higher for longer, particularly if energy shocks begin feeding into broader price-setting behavior.
For now, however, Morgan Stanley’s view suggests that the oil shock—while significant for markets and consumers—is unlikely to fundamentally alter the Fed’s easing trajectory.
