Iran Conflict: Will the Federal Reserve Delay Rate Cuts and Increase the Size of the Cuts?

Investing.com - The conflict involving Iran and the resulting oil price fluctuations are reshaping expectations for U.S. monetary policy. Morgan Stanley believes that the risk distribution currently favors the Federal Reserve delaying rate cuts, possibly with larger cuts.

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Morgan Stanley Chief U.S. Economist Michael Gapen said, “The distribution of monetary policy outcomes is asymmetric.”

Gapen pointed out that the Fed is “more likely to delay rate cuts or delay and implement larger cuts rather than completely abandoning easing.”

Morgan Stanley’s baseline scenario still expects two rate cuts in 2026, in June and September, assuming the Fed “ignores oil-driven price pressures and implements easing earlier than expected.” However, the firm emphasizes two major risks.

The first risk is that higher inflation and still-low unemployment may lead policymakers to wait.

“Inflation has reached 3.0% and is rising… Rising oil prices could push it further off target.” In this case, rate cuts might be delayed until September and December, or even December and March of the following year, but ultimately, the terminal range will still be 3.0%-3.25%.

The second risk has more far-reaching implications. If the Fed delays too long, tightening conditions could cause more severe damage to economic activity.

Morgan Stanley warns, “Prolonged high oil prices combined with increased uncertainty could harm demand more than we expect.”

In this scenario, the Fed could ultimately cut rates three times, lowering the terminal rate to 2.75%-3.0%.

Currently, Morgan Stanley maintains its baseline outlook but recognizes significant risks, namely that the Fed may delay rate cuts beyond our expectations or cut later and to a lower trough.

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