MS Sunday Start A Fed in Motion

M September 20, 2026 06:15 AM GMT

Sunday Start | What's Next in Global Macro Morgan Stanley & Co. LLC Global Idea

Seth B Carpenter Chief Global Economist

The Federal Reserve raised its policy rate by 25bp this week. The market had priced that move and more, so what matters now is less what happened, but why it happened … and what happens next vis-à-vis inflation and the reaction function. We had spent much of the year arguing that the Fed was likely to remain on hold because inflation was moving in the right direction, and we had assumed Chair Warsh preferred not to raise interest rates, if possible.

The inflation story is the clearer of the two. The six-month trend in inflation, the metric Chair Warsh referenced at Jackson Hole and again at the September press conference, is falling. The problem for the FOMC clearly is that it is not falling fast enough. The renewed surge in energy prices is an additional complication. We had assumed a benign path for oil prices, but supply disruptions and a revived risk premium have changed the picture. With too-slow disinflation and clear upside risks for energy, the FOMC had had enough.

But the reaction function narrative appears less clear-cut. Policy is decided by FOMC vote, and while the Chair has substantial sway, a new Chair cannot overhaul the process. In public comments before his appointment, Warsh made it clear that he thinks inflation is running above target because of the Fed balance sheet, not interest rates. The FOMC’s conventional interest rate tool has clearly won out for now as the Committee takes its decision.

The June dot plot already showed a meaningful number of participants leaning toward further tightening, with three dissents in favor of a hike in July. Regardless of who became Chair, a significant bloc within the committee remained uncomfortable declaring victory over inflation prematurely. The September hike should therefore be viewed not only as Warsh’s decision, but also as a reflection of where much of the committee already stood.

We do think investors should be careful not to over-interpret the dots. The median participant now expects only one additional hike, with an option for a second. We think the dot plot is best read as signaling direction rather than an explicit forecast: the Fed is willing to tighten further if inflation does not improve sufficiently. And now, more than ever, the distinction between voters and non-voters matters, so it could well be that a majority of those who will vote next year will want to take rates higher.

Looking forward, then, one question is whether the September hike marks the beginning of a regime shift or a correction within the current framework. We think it is latter. The statement said that the move was intended to get inflation to return to target in “timelier” fashion. Inflation is moving in the right direction, they just want the pace to be a bit faster. This is not a declaration that policy had been fundamentally wrong but a change of degree. For important disclosures, refer to the Disclosure Section, located at the end of this report.

So more hiking is likely, but perhaps less than what markets are pricing. Which brings us back to the key question: How does Chair Warsh intend to deliver price stability? He has been clearer about the balance sheet driving inflation than other aspects of policy, yet the balance sheet was absent from September’s press conference. That tension reinforces the likelihood that the market is looking for more rate hikes than this Fed may deliver. After his taskforces deliver their work, it may be that balance sheet reforms potentially reduce the need for aggressive rate increases.

We now know that the Fed has grown more concerned about inflation and is willing to act. But to us, this shift looks less like a new tightening regime than a recalibration to keep the disinflation process on track. Market discourse often refers to unwinding the so-called insurance cuts of last year, and that view may not be wrong. The economy can absorb these hikes. If the disinflation we expect continues, the degree of policy restraint that the Fed seeks will become clearer, and seems likely to be at the lower end of…