A Narrower Path for Growth and Stability

Arunima Sinha (0:00)

Welcome to Thoughts on the Market. I'm Arunima Sinha from Morgan Stanley's US and Global Economics teams. Today, I'll talk about what rising rates mean for economic activity, inflation, and the policy path. It's Monday, October 19th at 10 a.m. in New York.

The FOMC raised rates in September, but expectations for future hikes remain volatile. Within hours of the latest CPI print, markets round tripped, pushing the probability to even for an October hike before retreating.

Now, consistent with our baseline forecast, the market assigns December the highest likelihood for the next hike, but moves further along the US curve matter even more, notably, the 10-year yield shifted.

One question that arises taking a step back is how much we should worry that broad-based inflation upside means tighter policy is required to push down inflation and therefore growth, or have financial conditions tightened enough on their own that the central bank has less, not more work to do.

The calibration of monetary policy has always been difficult, and now it is becoming urgent. Economists try to put the level of interest rates into the context of where they stand relative to the economy's natural rate. Stronger productivity growth and investment demand should mean a higher natural rate, so a given level of rates is less restrictive. The rise in long-term treasury yields alongside still firm growth and earnings expectations is an indication that the neutral rate may indeed be higher. When yields rise because growth prospects are improving, expected returns rise and the demand for capital strengthens. In that setting, higher rates are not necessarily contractionary. But there is a less benign alternative. Yields have also risen because inflation has been hot, fiscal concerns are intensifying, and investors are demanding more compensation for holding duration. The question that Chair Warsh has posed, are financial conditions restrictive, is starting to get a different answer. Calibration will be key to how the economy evolves. For the US so far, even the most recent upside inflation surprise pointed to resilient demand rather than energy-driven stagflation. The simple explanation is that many firms still see returns well above their cost of capital. Recent work from our US economics team supports such a view.

Where there may be a contrast is at the sector level, and that seems to be becoming more apparent. If activity is concentrated in sectors driven by innovation, productivity and strategic investment, the economy may be less rate-sensitive than in past cycles. Calibrating policy amid these opposing forces is no easy task. The fact that we're seeing the biggest spread widening in the lowest quality part of the credit spectrum and the fact that housing activity is at recessionary levels are some tells in the US that policy and financial conditions are restrictive. The signs of tighter financial conditions are somewhat more visible in Europe in part because the AI capex spend is less of a factor. Growth has been resilient, but not sufficiently so to offset rising fiscal concerns from higher rates. The French OAT selloff shows how quickly the balance of risks shifts. Globally, financial conditions are introducing tougher conditions to the macro landscape. Until recently, the economy's message had been clear. Higher rates were restraining some sectors, but without meaningfully altering the expansion's trajectory. As long as expected returns rise alongside borrowing costs, then yields can remain high without becoming decisively restrictive. But as our rate strategy colleagues have noted, inflationary pressures have pushed up real rates, not break evens. So the market is telling us that policy is getting tighter to restrain growth and eventually pull down inflation. The latest inflation print in the US reinforces this debate. Are financial conditions restrictive? With several catalysts ahead, Q3 earnings, hyperscaler capex, credit spread widening, and the US elections, the Fed meeting coming up, markets will need to shift to assessing growth risks as central banks try to recalibrate.

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