Morgan Stanley predicts: At the Jackson Hole central bank annual meeting next week, Powell will "hawk," resisting market expectations for interest rate cuts

Just as the global market almost viewed the Federal Reserve's interest rate cut in September as a foregone conclusion, Wall Street's top investment bank Morgan Stanley issued a starkly contrasting heavy warning.

The report pointed directly to a "bad news" that the market has largely overlooked—far stickier service sector inflation than expected is forcing Federal Reserve Chairman Jerome Powell to adopt a hawkish stance at Jackson Hole.

Morgan Stanley predicts that at the highly anticipated Jackson Hole global central bank annual meeting next week, the market's eagerly awaited "green light" for interest rate cuts may not materialize. Instead, there will be a hawkish declaration aimed at strongly pushing back against the market's aggressive expectations.

93% Certainty: How Was the Market's "One-Way Street" for Rate Cuts Paved?

The logic of the financial market has appeared exceptionally clear and unified over the past month.

According to Morgan Stanley's latest report released on August 15, after the release of key inflation data, market traders still locked in a 93% probability for a 25 basis point rate cut in September, believing that a rate cut is almost a done deal.

This fervent consensus primarily stems from the weak employment report in July. The report not only showed a slowdown in job creation but also included a historical downward revision of as much as 258,000, leading investors to quickly conclude that the cooling of the labor market is far more rapid than imagined, and the risks of economic downturn can no longer be ignored.

Thus, the market narrative took shape: In the face of the risk that the employment engine may stall, as long as inflation data does not show a catastrophic surge, it is insufficient to prevent the Federal Reserve from initiating a preventive rate cut. The report described investors' mindset as follows:

"They saw the CPI data for July and concluded that it was not enough to offset the downside risks facing the labor market."

As a result, a "one-way street" leading to a rate cut in September seemed to be paved, with the market racing down this path.

Core Alert: The Real Trouble Is Service Inflation, Not Tariffs

However, amidst the market's collective optimism, Morgan Stanley's analysts identified hidden risks. They pointed out that the market's focus may be misplaced. The real trouble does not come from external tariffs but rather from the internal, more troublesome service sector inflation.

"This is an unexpected development for us," the report admitted, "the strengthening of core inflation is driven by services rather than goods." Data shows that the year-on-year growth rate of core CPI in July has quietly accelerated from 2.9% to 3.1%. Deeper data reveals that service prices, excluding energy, rose by 0.4% month-on-month, while the goods prices, which the market had previously been highly vigilant about due to tariffs, only rose by 0.2% month-on-month.

Why is this considered "bad news" in Morgan Stanley's view? The report provided a profound explanation: "The strengthening of service inflation may pose a worse outlook for (policy) because it is stickier." Unlike goods prices, which are influenced by global supply chains and tariffs and are more volatile, service inflation is primarily driven by domestic labor costs, rents, and other endogenous factors. Once an upward trend is established, it is difficult to dissipate in the short term.

The report further emphasized that the Federal Reserve "finds it more challenging to deal with resilient service inflation." Although analysts acknowledged that the jump in service inflation in July was partly exaggerated by volatile categories such as "airfares and dental services," a more alarming signal comes from the Producer Price Index (PPI)—the prices for final demand services in the PPI surged by 1.1% in July This indicates that future terminal inflation pressures should not be underestimated.

Applying the brakes to the market's fervent expectations

This subtle yet crucial change in the inflation structure has pushed Federal Reserve Chairman Jerome Powell into an extremely difficult position. His greatest fear at the moment is not the economic data itself, but being "hijacked" by the market's fervent expectations before key decision-making moments arrive.

Morgan Stanley repeatedly emphasizes in its report that the Federal Reserve's core demand is to "retain optionality," especially unwilling to be "cornered" by the market before the complete employment and inflation data is released in August.

The risks of this situation are extremely high. The report pointedly states: "If the Federal Reserve allows the market to price in rate cuts with near certainty, it will become very difficult to avoid a rate cut in September." Given that the market had already priced in a 23 basis point rate cut at that time, "not cutting rates would be equivalent to a rate hike," which could trigger severe turmoil in the financial markets, a scenario the Federal Reserve is keen to avoid.

Therefore, Powell must take action to "apply the brakes" to the market's fervent expectations.

Supporting his "hawkish" stance is the fact that the views within the Federal Reserve are far from unified and can even be described as increasingly polarized. At the last monetary policy meeting, Governors Waller and Bowman cast dissenting votes. Recently, several hawkish officials, including St. Louis Fed President Jim Bullard and Kansas City Fed President Esther George, have publicly expressed concerns about the upside risks of inflation.

The most compelling signal comes from Chicago Fed President Austan Goolsbee, who is historically known for his dovish stance. In a speech on August 13, he unexpectedly "turned hawkish," explicitly stating that the resilience of service sector inflation is "bad news," and described the labor market as having cooled from "very hot" to "sustainable full employment." The implication of his remarks is that his concerns about the job market have significantly diminished, while his vigilance regarding the persistence of inflation is sharply increasing.

When even former "doves" begin to sound the alarm on inflation, the market's certainty about rate cuts appears particularly fragile.

Conclusion: A storm of "expectation management" to regain policy initiative for the Federal Reserve

Overall, next week's Jackson Hole conference may be a crucial "expectation management" storm personally orchestrated by Powell.

Morgan Stanley predicts that Powell's speech will send a clear signal: it is still too early to predict the final impact of tariffs, and inflation issues are more prominent and challenging than employment issues. He will not completely close the door on a rate cut in September, but his core task is to break the market's "inevitability of rate cuts" narrative and regain policy initiative for the Federal Reserve, waiting for more data to emerge.

For global investors, it is essential to be vigilant and prepare for potential market corrections that may arise from "expectation gaps." The message Powell is about to send is likely to be—before seeing the next key data, everyone needs to remain patient and "let the bullets fly for a while longer."