Morgan Stanley: Is 2% inflation within reach yet still out of grasp? The Federal Reserve is also "waiting for signals" to cut interest rates

According to the Zhitong Finance APP, on June 12, JPMorgan Chase released the "United States: Mid-term Economic Outlook for 2025," stating that trade tensions are expected to lead to economic growth in the United States falling below trend levels in the second half of the year. The three main core predictions are: first, consumer income growth should help the economy avoid recession; second, the trend of cooling inflation is expected to rebound this summer; third, the Federal Reserve is likely to remain patient and will not make the next interest rate cut until December.

The following are the main points from the JPMorgan Chase report:

Our 2025 outlook is based on two premises: first, strong momentum in the business cycle at the beginning of the year, and second, that policy risks are two-sided. Over the next six months, this strong momentum is expected to persist, with steady growth in employment and spending. As we anticipated, with a clearer understanding of policy, the impact of policy has been mixed, but we believe its friendliness towards growth has declined. Notably, tariffs and trade policies have become the biggest drivers of our revised forecasts. The stagflation impact from higher tariffs has led us to lower our GDP growth forecast for this year (year-on-year for the fourth quarter) from an initial 2.0% to the current 1.3%.

However, policies have also provided some offsetting factors that support growth. The recent legislative approval of Social Security benefit increases has raised personal income in recent months, offsetting some of the tax burden brought about by increased tariffs. Partly for this reason, we have raised our forecast for annualized real GDP growth in the third quarter to 1.0% (Figure 1). Personal income is also expected to receive some support from the "One Big Beautiful Bill" currently under consideration in Congress, which we expect to pass in modified form before the August recess. These offsetting factors should limit the risk of higher tariffs dragging the economy into recession. Nevertheless, we still believe that the risk of recession remains high, with about a one-third probability of the economy contracting over the next four quarters.

Figure 1: Real GDP and Non-farm Employment

(Left vertical axis: quarter-on-quarter, annualized growth rate; right vertical axis: thousands, monthly change forecast)

The core Personal Consumption Expenditures (PCE) inflation rate has "perfectly" fallen from a peak of 5.6% in 2022 to a recent 2.5%, but now faces the risk of reversal. We expect that the pass-through of tariffs to consumer prices will push the annualized core PCE inflation rate to 4.6% in the third quarter. After that, we believe inflation will ease somewhat. Although inflation expectation survey indicators are high, we believe that a softening labor market will limit workers' ability to demand and receive wage increases, which would otherwise fuel a wage-price spiral (as occurred in the early stages of the cycle). Even so, we expect core PCE to remain at a troubling high of 3.4% by the end of the year (year-on-year for the fourth quarter) Federal Reserve officials unanimously stated that they wish to first observe the impact of higher tariffs on the economy before taking action. We believe their statement and think the next interest rate cut will not come until December. We expect three consecutive rate cuts in early next year, after which the federal funds rate target will stabilize at 3.25%-3.50% (Figure 2).

Figure 2: Core CPI and Federal Funds Rate

Table 1: Effective Tariff Rate Test

Our static estimate (assuming trade shares remain at 2024 levels) has fluctuated over the past few months and is currently around 14%. This proportion may rise once the investigations by the Office of the United States Trade Representative (USTR) conclude. However, as China's trade share declines, this proportion will also decrease.

Imposing an average effective tariff of 14% on $3.1 trillion worth of imports translates to an additional tax burden of over $400 billion on American businesses and consumers. There is no definitive conclusion on how this tax burden will be shared between businesses and consumers, but based on historical experience, we assume that consumers will bear most of the burden. Recent business surveys indicate that this is likely to happen again. Rising prices act as an indirect tax on purchasing power, and we believe this will cast a shadow over the otherwise optimistic consumer spending outlook.

We also believe that the ongoing uncertainty in global trade rules will affect capital expenditures, which is consistent with recent survey results. Finally, U.S. policies are putting pressure on the global economic growth outlook, thereby suppressing foreign demand for U.S. exports.

Coming Soon: Slowing Job Growth

It is well known that a decrease in immigration will lower the breakeven (or steady-state) figure for monthly job growth. However, recent benchmark revisions show that this slowdown has occurred earlier than expected. As mentioned earlier, recent data suggests that last year's average monthly job growth may have fallen below 100,000. This was still the case before the significant slowdown in the growth of foreign-born labor this year.

If labor supply falls below 100,000 per month, even a slight cyclical weakness could occasionally lead to negative monthly job growth. While we no longer forecast negative job growth on a quarterly basis, it would not be surprising to see negative values in monthly job data.

Worker behavior has already indicated that a cooling labor market seems to be upon us. Whether through the Job Openings and Labor Turnover Survey (JOLTS) or household survey data, the resignation rate has fallen from its post-pandemic peak. This phenomenon is significant because the resignation rate is one of the best leading indicators of wage growth. Therefore, while we expect wage increases will not return to the subdued levels of the last economic expansion, we also doubt they are likely to exceed 4% 2% Inflation: Close at Hand, Yet Elusive

In the remaining time this year, the inflation narrative is likely to revolve around tariffs. As of May, there is little evidence to suggest that tariffs have had a significant impact on consumer prices. However, drawing from the experiences of 2018-2019, we expect the peak impact of tariffs on consumer prices to take 2-4 months to materialize. Recent surveys from the New York Fed and the Atlanta Fed also indicate that there is a similar lag between the implementation of tariffs and the effects reflected in the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) price index. Therefore, we may see the peak impact of tariff transmission during the June-August period.

The persistence of the anticipated inflation shock may be influenced by two factors. First, inflation expectations have remained elevated. At a recent Federal Reserve framework review meeting, economist Yuri Gorodnichenko from the University of California, Berkeley emphasized that inflation expectations have not been anchored. The second factor is the state of the labor market. Unlike the overheated labor market of 2021-2023, the current situation should limit workers' ability to demand wage increases to cope with rising living costs. In line with Governor Waller's (a Federal Reserve official) views, we believe that the breakdown of the wage-price link should constrain the persistence of the anticipated inflation shock.

However, even with a currently dovish stance, Waller cannot be completely certain that the inflation shock is temporary. If he lacks this confidence, we believe others on the committee will as well. This will reinforce their tendency to wait, and we expect the next rate cut to occur in December, long after the peak of inflation data. We anticipate three rate cuts in early next year, and the timing will be earlier than expected. Before the next rate cut, the Federal Reserve's framework review will reach conclusions (likely by late summer this year), and the new framework is expected to have many similarities to the framework prior to 2020. Finally, the timing of the next rate cut by the Federal Reserve Chair is almost as contentious as the selection of the next Federal Reserve Chair. While we cannot predict, we believe the Federal Open Market Committee (FOMC) will strive to ignore social media headlines and focus on the economic situation