Editor's note: After the Fed restarted rate hikes, market discussion is rapidly shifting from "whether to hike in September" to "whether this is the starting point of a new hiking cycle." The 25 basis points itself has already landed; what truly affects asset pricing is how many more hikes there will be, how far apart they will be, and what conditions will make the Fed stop. But as "inflation is still above target, so policy needs to be tighter" gradually becomes consensus, a more fundamental question begins to emerge: if current inflation itself is not mainly driven by traditional demand overheating, then how much can rate hikes actually solve?

In Morgan Stanley's latest issue of Thoughts on the Market, Chief U.S. Economist Michael Gapen and Global Macro Strategy Head Matthew Hornbach discussed the policy path after the September rate hike from the perspectives of the economy and the rates market, as well as the emerging relationship among inflation, energy prices, and U.S. Treasury yields.

In this conversation, what Morgan Stanley truly breaks down is not the single forecast of "whether the Fed will continue hiking next time," but a set of more fundamental structural questions: where current inflation comes from, where interest rate tools can act, and how the market should judge how far this round of tightening will go.

First, the target of rate hikes has changed. Past typical tightening cycles often corresponded to demand overheating: strong consumption, rising wages, and credit expansion, with central banks suppressing aggregate demand by raising financing costs. But this time, a considerable portion of inflation comes from energy, tariffs, and supply-side changes, while AI investment provides new structural demand. For these factors, raising rates by 25 basis points or even more may not necessarily directly curb price pressures. This means that although the Fed can use higher rates to suppress real estate, traditional investment, and other rate-sensitive sectors, it may be unable to precisely address the core sources driving current inflation. Policy therefore faces a kind of mismatch: it needs to tighten, but the sectors being tightened are not necessarily the sectors creating inflation.

Second, "prepared to keep hiking" and "ultimately keeps hiking" are becoming two different questions. According to Gapen's judgment, the Fed will not start hiking just because it believes 25 basis points is enough to change the macroeconomic outlook. Once a long pause ends and action resumes, policymakers usually assume there will be a series of adjustments ahead. Therefore, from the ex ante policy logic, this hike does not look like an isolated move, and there is room for at least one or two further actions. But monetary policy is ultimately data-dependent. If three-month and six-month annualized inflation continue to decline in the coming months, the Fed could very well maintain hawkish language while choosing not to act when a real decision is needed. At that point, "one and done" is not the original design, but the result of changed data.

Third, the variable determining the next hike is shifting from employment to the composition of inflation, especially energy prices. In the past, the market was used to trading the Fed around nonfarm payrolls, the unemployment rate, and wage data, but Morgan Stanley believes the labor market is currently neither strong enough to recreate obvious inflationary pressure nor weak enough to force the Fed to pivot quickly. By contrast, fluctuations in Brent crude, WTI, and gasoline prices are more directly changing the market's pricing of the policy path: when energy rises, the market tends to increase rate-hike expectations; when energy falls, hawkish pricing weakens. This means that in judging Fed policy in the coming months, one cannot look only at "whether the economy is strong," but also at which prices are driving inflation and whether those prices are sensitive to interest rates.

Fourth, the core of Treasury market trading is still the policy path, not the total amount of debt itself. U.S. federal debt growing from about $31 trillion to $40 trillion has not mechanically corresponded to a sustained rise in 10-year yields. Hornbach emphasizes that more important than the absolute scale of debt is whether debt expansion exceeds market expectations. On the contrary, the more direct backdrop for the 10-year Treasury yield rising from about 4.25% to 5% this year is that the market shifted from once pricing two rate cuts to pricing multiple rate hikes. Long-term rates are therefore not simply trading "the U.S. debt is getting bigger and bigger," but reassessing the balance among future monetary policy, inflation, and Treasury supply over the next few years.

If this conversation is compressed into one judgment, it is this: the Fed is not subjectively starting this round of action on the basis of "one hike," but the current inflation structure determines that this tightening cycle could ultimately be terminated early by the data.

In this sense, what the market is now discussing is no longer just whether the next FOMC meeting will raise rates by another 25 basis points, but a more important question: as inflation is increasingly driven by supply shocks and structural investment, to what extent can traditional interest rate tools still dominate the inflation and asset price cycle.

The original text is as follows (the original content has been edited for easier reading and comprehension):

Key Takeaways from the Discussion

The Federal Reserve ended its prolonged pause and resumed rate hikes at its September meeting with a 25 basis point increase.

But for the market, the truly important question is not the 25 basis points itself, but whether this is merely a policy calibration or a signal that more rate hikes are on the way.

Morgan Stanley Chief U.S. Economist Michael Gapen and Global Head of Macro Strategy Matthew Hornbach argue in the latest edition of "Thoughts on the Market" that, based on the Fed's own policy logic, this rate hike was most likely not designed as a "one-and-done" move.

On the other hand, the current sources of inflation and the data trajectory over the coming months could ultimately make this rate hike cycle a de facto "one and done" in hindsight. In other words, the Fed may be prepared to keep hiking, but may not actually be able to follow through.

Why Resume Rate Hikes Now? Inflation Isn't Falling Fast Enough

Gapen believes the most direct message from this rate hike is that inflation is still not declining at the pace the Fed wants to see. As long as inflation remains above target, the most direct policy tool the Fed can deploy is still tightening monetary policy.

But the problem is that this bout of inflation does not entirely stem from traditional economic overheating.

Morgan Stanley believes a significant portion of price pressure comes from the supply side, including tariffs, energy prices, and the deglobalization trend that has persisted over the past few years. Additionally, AI-related investment is creating new demand pressure in certain sectors.

This makes the current environment different from typical demand-driven overheating. If inflation comes from consumption, credit, and investment growing too fast, then raising rates can cool the economy by suppressing aggregate demand. But if price increases mainly come from energy, trade barriers, or supply chain changes, the role interest rates can play is far more limited.

AI investment presents a similar problem.

Investment demand in areas such as data centers, chips, and power infrastructure remains strong, and Morgan Stanley does not believe that a modest rate increase would significantly suppress this structural capital expenditure.

As a result, the Fed finds itself in an awkward position: it must respond to high inflation, but what rate hikes can actually suppress is more likely real estate, traditional investment, and other already weaker, more rate-sensitive sectors of the economy.

This is also why Morgan Stanley believes there remains significant uncertainty over whether this round of rate hikes can truly resolve the current inflation problem.

Why one rate hike may not be enough? The Fed typically doesn't move just 25 basis points

Although the causes of current inflation are complex, Gapen does not believe the Fed will initiate this round of action with a "one-and-done rate hike" mindset.

The reason is simple: monetary policy typically doesn't work that way.

The Fed had already held rates steady for an extended period, and once it decides to change policy direction again, it usually means policymakers believe the macroeconomic environment has shifted enough to warrant a series of policy adjustments.

A single 25 basis point change can hardly fundamentally alter the economic and inflation outlook. Therefore, in Gapen's view, if the committee has already decided to hike, it most likely won't internally believe "this one time is enough," but rather would preset room for at least 1 to 2 more moves.

In other words: from policymakers' ex-ante perspective, this looks more like the first step of a potential rate hike cycle rather than an isolated action.

This is largely consistent with current market pricing. After the September rate hike is completed, the rates market still implies expectations of about three additional hikes.

Why might it ultimately be just one hike? Data could put the brakes on the Fed

However, "the Fed is prepared to keep hiking" does not equal "subsequent hikes will definitely happen."

Gapen specifically distinguishes two concepts: how the Fed designs policy ex-ante, and what actually happens when the market looks back ex-post.

Currently, U.S. three-month and six-month annualized inflation indicators have already shown some disinflationary trends. If this trend continues in the coming months, a scenario could emerge: the Fed completes its first rate hike in September while continuing to tell the market "there's more work to do," and internally was originally prepared to hike once or even twice more.

But by the time the next decision point arrives, inflation has improved enough that a second hike becomes unnecessary. In that case, looking back, this cycle would effectively become a "one and done" — hike once, then stop.

The key point is that this is not the Fed planning from the start to hike only once, but rather subsequent data changing the policy path.

In the coming months, there is another factor that could influence policy judgments: the U.S. Bureau of Economic Analysis's methodological adjustments to PCE inflation data.

Morgan Stanley expects that some statistical changes, including software quality adjustments, could over the long term reduce measured year-over-year inflation by an average of about 0.1 percentage points, or perhaps slightly more. 0.1 percentage points may not seem like much, but when monetary policy is on the edge of "whether to hike one more time," such a change could carry real significance.

This is also why Gapen believes that even if the Fed continues to raise rates, this cycle may not necessarily turn into rapid rate hikes across three or four consecutive meetings. By comparison, a slower pace—such as roughly once per quarter—may be more reasonable.

This would give the Fed more time to observe two things: first, whether inflation itself continues to decline; and second, how much the PCE data revisions will adjust the inflation path downward.

Therefore, a scenario like this is entirely possible this year: one hike in September, followed by a wait-and-see approach, and ultimately no further action because inflation improves.

What determines whether there will be another hike next time? Energy prices are more critical than employment

So what data deserves the most attention next? Morgan Stanley believes the importance of the labor market is declining.

Gapen describes employment as the "second or even third-tier variable" in current monetary policy. On the one hand, U.S. wage and labor income growth is still slowing, showing no obvious wage-price spiral and not supporting the judgment that "the economy is overheating again." On the other hand, if recent months' job gains are smoothed out, they are roughly maintained at about 50,000 to 70,000 per month.

This level is not strong, but it is also not weak enough to force the Fed to quickly stop tightening. By comparison, Hornbach believes the bond market is now paying more attention to energy prices.

Morgan Stanley observed that when Brent crude, WTI crude, and gasoline prices rise, the market typically reprices a more hawkish Fed path; and when energy prices fall back, future rate hike expectations also decline accordingly.

The reason is not complicated. Energy prices both directly push up headline inflation and affect the market's judgment of future inflation stickiness.

Therefore, in the current environment: oil prices may be more likely than a single month's employment data to change the market's judgment on the next rate hike.

The market is already trading more rate hikes, but the path could still reverse

This shift in policy expectations has been clearly reflected in the U.S. Treasury market. Earlier this year, the market was once pricing in two Federal Reserve rate cuts, when the 10-year U.S. Treasury yield was around 4.25%.

Now, with policy expectations completely reversed, the market has moved from "two rate cuts" to pricing in about four rate hikes, including actions already taken, and the 10-year Treasury yield has risen to around 5%.

Hornbach believes this shows that current changes in long-term interest rates are highly correlated with how the market understands the Fed's future policy path. In contrast, even as U.S. government debt continues to expand, the sheer total amount of debt alone cannot well explain Treasury yields.

He gave an example: about four years ago, U.S. federal debt was about $31 trillion, when the 10-year Treasury yield was once around 4.25%. Earlier this year, U.S. debt had risen to about $40 trillion, but the 10-year yield had still once returned to a level close to 4.25%.

An increase of about $9 trillion in debt over four years did not produce a clear difference in long-term interest rates between these two points in time. Hornbach therefore argues that what the market cares about more is not how "large" the debt is, but whether the pace of debt growth significantly exceeds investors' previous expectations. At least for now, the Fed's policy path remains the more direct variable affecting Treasury yields.

So, this September rate hike is more like a starting point than an answer. From the Fed's own decision-making logic, one 25 basis point move is likely not enough, and more hikes remain among the policy options. But what truly determines whether these hikes can materialize is not what the Fed says today, but whether the data in the coming months will change its mind.

If energy prices remain elevated and disinflation stalls, more hikes may continue to be priced in by the market; but if the disinflation trend continues, this rate hike cycle that appears to have restarted may ultimately leave only this one 25 basis point move.

Welcome to join the official BlockBeats community:

Telegram Subscription Group: https://t.me/theblockbeats

Telegram Discussion Group: https://t.me/BlockBeats_App

Official Twitter Account: https://twitter.com/BlockBeatsAsia