Morgan Stanley predicts: Inflation in the U.S. will rise starting in May, the Federal Reserve will not be able to cut interest rates this year, and there will be no major fiscal stimulus in the U.S

Against the backdrop of stable trade, U.S. economic activity may show inflation rising first, followed by a weakening of economic activity, which could lead the Federal Reserve to maintain a wait-and-see approach in 2025.

According to news from the Chase Trading Desk, Morgan Stanley stated in a report on May 16 that although the recent U.S.-China trade tensions have eased, U.S. inflation is expected to rise significantly starting in May, with the annual inflation rate possibly reaching 3.0-3.5%, which will force the Federal Reserve to keep interest rates unchanged in 2025. Progress in U.S. fiscal negotiations indicates that the fiscal stance will remain largely unchanged, lacking large-scale stimulus measures. For investors, this means that the U.S. economy will enter a combination of low growth and high inflation, and asset pricing will need to adapt to the new reality of "no rate cuts."

Federal Reserve to Remain Steady in 2025

According to official news from the Ministry of Commerce, on May 10-11 local time, the Chinese lead in U.S.-China economic and trade talks, Vice Premier He Lifeng, met with the U.S. lead, Treasury Secretary Janet Yellen and Trade Representative Katherine Tai, in Geneva, Switzerland. This high-level U.S.-China economic and trade meeting achieved substantial progress, significantly reducing bilateral tariff levels, with the U.S. canceling a total of 91% of the increased tariffs, and China correspondingly canceling 91% of the counter-tariffs; the U.S. also suspended the implementation of a 24% "reciprocal tariff," and China similarly suspended the implementation of a 24% counter-tariff.

Morgan Stanley analysts stated that although the de-escalation of trade conflicts has greatly reduced the risk of a hard stop in trade flows, thereby lowering the likelihood of a near-term economic recession, the effective tariff rate of 13% remains significantly higher than the approximately 2% at the beginning of the year, and policy uncertainty remains very high, with recession risks still evident.

Morgan Stanley expects that after tariffs are reduced to more manageable levels, the high-probability outcome is that inflation will rise first, followed by a weakening of economic activity. Tariffs have not yet manifested in inflation data, with the April CPI report showing overall and core inflation rising moderately by 0.22% and 0.24%, respectively, and core commodity prices only increasing by 0.1%.

Looking ahead, Morgan Stanley predicts that tariffs will significantly push up inflation starting in May and accelerate thereafter. Their forecast for the month-on-month growth rate of core PCE inflation in May is 0.3%, with June, July, and August at 0.5%, 0.7%, and 0.5%, respectively. By the end of the year, tariffs should drive the annual inflation rate to 3.0-3.5%.

Based on this forecast, Morgan Stanley maintains its outlook that the Federal Reserve will not cut interest rates in 2025, believing that the degree to which inflation deviates from the Federal Reserve's 2.0% target this year will exceed the degree to which employment deviates from maximum employment levels. They expect the Federal Reserve may begin to cut rates in March 2026, at which point a slowdown in economic activity and reduced labor demand will push up the unemployment rate For investors, the U.S. economy may be entering a phase of slowing growth but rising inflation, with the Federal Reserve expected to keep interest rates unchanged in 2025. This combination poses significant challenges for asset markets, particularly for asset classes that rely on expectations of Fed rate cuts.

Fiscal Negotiations Indicate Little Change in Fiscal Position

The budget proposal previously passed by the House Ways and Means Committee will increase the deficit by $3.8 trillion over the next 10 years.

Morgan Stanley pointed out that the state of negotiations leads them to believe that there will be no significant changes to the fiscal position. The original draft of the proposal indicated a $4.5 trillion increase in the deficit over 10 years, with approximately $4.0 trillion coming from the extension of the Tax Cuts and Jobs Act (TCJA).

Analysts believe that the holders of SALT (State and Local Tax Deduction cap) in the House and the Senate's resistance to significant cuts in Medicaid spending will push the total scale of the plan to $4.0-$4.5 trillion over 10 years. In short, the extension of the TCJA occupies most of the space in this bill, and any spending cuts may be used to offset tax reductions elsewhere (such as exemptions for tips, overtime, auto loans, etc.).

The risks lie in two areas that could lead to a higher deficit: first, Senate Republicans often oppose significant cuts to entitlement programs, which may mean that spending cuts intended to offset tax reductions will not materialize; second, the new tax cuts in the House proposal will expire in 2028, thereby reducing their estimated cost over 10 years, but historically, Congress has struggled to allow tax cuts to expire. If these tax cuts remain unchanged over 10 years, the estimated increase in the deficit from the House budget proposal could exceed $5.0 trillion.

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