MS July FOMC A question of patience

US Economics Weekly | North America Morgan Stanley & Co. LLC Idea

Michael T Gapen Chief US Economist

Economist Recent data have strengthened the case for a patient Fed, with Arunima Sinha Global Economist softer payrolls and easing inflation. We expect the Fed to keep

rates on hold next week and through the remainder of the year. Heather Berger Economist Risks remain skewed toward higher rates, particularly following

the recent escalation in the Middle East. Lingdi Xu Economist

Key Takeaways We expect the Fed to hold rates at 3.50–3.75% in July, with recent labor market and inflation data supporting a patient, wait-and-see approach.

Labor market overheating concerns have eased and last CPI report suggests that, absent additional shocks, more disinflation might be in the pipeline.

Upside risks to rates include persistently high oil prices, a more hawkish Fed reaction function, or stronger AI-driven investment lifting neutral rates.

The temporary Section 122 tariff bridge expired earlier today, but we expect the broader tariff regime to remain, combining section 301 and 232 authorities.

Our baseline remains that the statutory effective tariff rate converges toward ~10% by year-end, similar to levels before the expiration of section 122 tariffs.

Exhibit 1: Higher oil prices remain a risk to our outlook for disinflation

Brent oil prices ($/bbl) 130 March FOMC June FOMC 120

50 Jan-26 Feb-26 Mar-26 Apr-26 May-26 Jun-26 Jul-26

Source: Bloomberg, Morgan Stanley Research

For important disclosures, refer to the Disclosure Section, located at the end of this report.

July FOMC: A question of patience Despite a rebound in oil prices, hikes are less compelling

The question hanging over the July FOMC meeting is whether the Fed will display patience or whether it has run out of patience. We believe the former. At next week’s meeting, we expect the Fed to keep the target range for the federal funds rate unchanged at 3.50- 3.75%. Since the committee met in June, the bulk of incoming data supports patience, in our view. The June employment report revealed a moderation in hiring and saw downward revisions to prior months. The rebound in hiring early in the year remains evident, but now appears shorter lived than the as-reported data suggested. Nonfarm payrolls rose 57k on the month, and longer-term averages are about in line with our estimate of breakeven payroll growth (~50k per month), leaving the unemployment rate little changed at 4.2%. Wage growth in terms of average hourly earnings is up only 3.5% y/y. Risks to the labor market appear balanced to our eyes and concerns about overheating have diminished.

Recent inflation data suggest to us that disinflation has begun. Headline CPI prices declined 0.4% and core was flat. Our three drivers of disinflation — a reversal in energy prices, the end of tariff pass-though, and diminishing shelter inflation — all contributed to the soft print. The tariff pass-through to core goods prices has now been flat since February, providing a strong signal that the corporate sector has adequately adjusted prices to account for higher production costs. If so, our estimates suggest as much as 60- 70bp of disinflation may be in the pipeline, providing an important source of disinflation. As we note below, we think the resolution of Section 232 and 301 reviews this week will move tariffs back to their IEEPA-based rates over time, but not above.

On net, we think the committee will read the data as we do and remain on hold in July. Inflation has shown enough improvement to buy more time and keep the Fed on the sideline. We think subsequent inflation prints will continue to point to disinflation — our m/m readings on core inflation in the second half of that year annualized close to 2.0% — and expect the Fed to remain on hold through year end.

That said, there are clear risks to our outlook in the direction of higher policy rates. First, the Fed could conclude the distribution of risks to the dual mandate favors a tighter policy stance. Second, our inflation forecast could be wrong and renewed escalation in the Middle East and the rebound in oil prices will lead to a higher oil risk premium outcome, boosting core inflation through…