The Federal Reserve is hawkish, and Emerging Markets are not feeling great, but Morgan Stanley is very confident.

On December 20, Morgan Stanley's economist for the USA, Michael T Gapen, and his team stated that the current hawkish outlook of the Federal Reserve is in line with their predictions—Trump's trade and immigration policies may keep inflation robust and delay further interest rate cuts by the Federal Reserve.

Morgan Stanley indicated that the timing and magnitude of interest rate cuts depend on the implementation progress of Trump's restrictive policies; however, the impact of these policies on economic activity may also lag, therefore, although the Federal Reserve is currently hawkish, it may shift to a dovish stance later. Just like in 2018, the Federal Reserve predicted further rate hikes but ultimately chose to cut rates when economic activity slowed.

Currently, the Federal Reserve has clearly indicated that if Trump's new administration's policies trigger inflationary pressures, the Federal Reserve will slow down the pace of unwinding restrictive policies and may even raise rates in certain cases.

However, Goldman Sachs believes that in the long run, these policies may have a more negative impact on economic growth than the short-term shock on inflation, prompting the Federal Reserve to cut rates to support the labor market. If that is the case, Goldman Sachs believes that the Federal Reserve in December this year may face a situation similar to that of December 2018.

In 2018, the Trump administration began to implement tariffs and gradually expanded the range of products and countries targeted, leading to import price pressures that drove inflation to the long-unachieved 2% target. At that time, the Federal Reserve was not overly worried about the risk of rising inflation, but the committee still believed that further tightening of policies was necessary.

In September 2018, the Federal Reserve anticipated three rate hikes in 2019 and one in 2020, but by December 2018, this forecast was downgraded to two hikes in 2019 and one hike in 2020. Ultimately, as manufacturing output continued to decline, the Federal Reserve remained on hold and eventually shifted to rate cuts in July 2019.

Goldman Sachs: The Federal Reserve's expectations align with ours.

At the FOMC meeting on December 18, the Federal Reserve cut interest rates by 25 basis points as expected, but released a hawkish forward guidance, with the dot plot indicating only two rate cuts are expected in 2025 instead of the previously anticipated four.

The Federal Reserve stated that the growth of economic activity in the USA will slightly slow within the expected range, the unemployment rate will remain at a low level, and inflation is notably more robust, thus indicating fewer rate cuts expected next year.

Analysts pointed out that the Federal Reserve's focus has shifted from the downside risks in the labor market to concerns about inflation re-ignition, especially after Trump took office, as tariff increases, immigration restrictions, and loose fiscal policies could pose significant upside risks to inflation.

Goldman Sachs stated that these comments from the Federal Reserve do not indicate a more hawkish stance, as the Federal Reserve still has a relatively high tolerance for inflation above the target value. The latest forecast shows inflation won't return to the target value of 2% until 2027, a full year later than previously predicted; however, the guidance released by the Federal Reserve remains about reducing rather than increasing restrictions.

Goldman Sachs added that the Federal Reserve's updated forecasts align closely with their expectations:

Assuming USA's external tariffs peak in the fourth quarter of 2025, and the number of immigrants falls to 1 million in 2025 and 0.5 million in 2026, Goldman Sachs expects USA's real GDP growth to slow to below 2% next year, with lagged effects appearing in 2026, further slowing real GDP growth. Meanwhile, core PCE inflation remains at 2.5% and the unemployment rate approaches the current 4.2%.

As for the Federal Reserve's path for rate cuts, Goldman Sachs expects only two 25 basis point cuts in 2025, but will continue to cut rates until they reach 2.6% by the end of 2026.

Editor/lambor