Morgan Stanley flags Fed hike risk if unemployment drops below 4%

Investing.com -- Morgan Stanley has retained its forecast for the Federal Reserve to hold interest rates through year-end, but warned that a drop in unemployment below 4% or persistently elevated inflation could force a rethink in favor of rate hikes.

In a note to clients, analyst Michael Gapen said incoming data since the June FOMC meeting has made it "marginally more comfortable" in its no-hike baseline, citing falling oil prices following the U.S.-Iran memorandum of understanding and an expectation that tariff pass-through is ending.

The bank forecasts fourth-quarter headline and core PCE inflation of 3.2% and 3.0%, respectively, "substantially below the median FOMC participant."

On the labor market, Morgan Stanley projects payroll gains of 50,000 to 60,000 per month over the summer, enough to keep unemployment roughly steady.

However, Gapen warned that "if the unemployment rate falls below 4.0%, the Fed may see risks of an overheating labor market as justifying rate hikes."

On inflation, Morgan Stanley said it expects monthly core PCE and CPI readings of 0.2% or below in the coming months.

"If monthly rates of core inflation remain at 0.3% month-over-month or higher, or if the conflict in the Middle East resumes, then our thinking could change," Gapen wrote.

The bank also suggested the Fed's own inflation projections may be overstated, noting forecasts were likely formed before oil prices fell sharply following the U.S.-Iran agreement, leaving nine FOMC participants' rate hike projections potentially based on stale assumptions.

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