The Global Rate Debate

**Seth Carpenter** (0:00)
Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Global Chief Economist and Head of Macro Research. And once again today, I am joined by Morgan Stanley's Chief Regional Economist, Michael Gapen, the Chief US Economist, Jens Eisenschmidt, our Chief Europe Economist, and on the other side of the world, Chetna Ahya, our Chief Asia Economist. Yesterday, we talked about what's supporting growth around the world, especially AI spending in the US and some government spending in Europe, and Asia's role in making all of this happen.
Today, we're going to try to dig deeper and go into policy. It's Tuesday, July 21st, at 10 a.m. in New York.

**Jens Eisenschmidt** (0:35)
And 4 p.m. in Frankfurt.

**Chetan Ahya** (0:37)
And 10 p.m. in Hong Kong.

**Seth Carpenter** (0:40)
Since the last time we did this in mid-April, I will say the debate around central banks has probably become more complicated. Global growth has held up, probably better than many people expected, and inflation, which picked up a lot, started to recede, but it has not gone away.
And some of the forces helping to shape the economy, the AI spending, government spending, that possible upswing in manufacturing, that could keep demand strong and it might keep pushing inflation higher. So the question today is, if growth remains resilient, how much room, really, do central banks have to navigate? Mike, let me start with you because your call for the Fed here in the US is out of consensus, or at least at odds with where the market is pricing things.
We talked about the demand going from AI, you pointed out that imports are actually limiting how much domestic demand there is. So what is the underlying story for inflation in the US? And what does it mean for the Fed?

**Michael Gapen** (1:37)
So our view is that inflation will come down in the US. So we think disinflation will be driven by some payback in energy prices, some payback from tariffs, which have pushed up goods prices over the last year, and some further diminishment in housing related inflation, namely shelters. And we think on a broad-based perspective, inflation has already peaked and will start moving lower. And we think we've seen evidence of this in recent inflation prints.
A risk to that, though, is from the demand side of the economy and AI related inflation in two parts.
One, higher software prices, chip inflation, so the pass through of some of the AI pricing components. Fortunately here, there are about less than 1% of the consumer basket. So we don't think that there's a great risk, a strong risk, a high risk of AI related inflation in the consumer bundle. I think the real risk is that maybe we underestimate broad based demand, animal spirits. And so you might just see a broad based increase in inflation from stronger demand. That'll be a little bit harder to see in real times, but our expectation is that inflation moves lower to about 3% by the end of this year and closer to 2.5% next year.

**Seth Carpenter** (2:56)
All right. Thanks, Mike. And in fact, the most recent inflation report that we just got confirms your perspective that inflation should be coming down. And so I guess the question then remains, what would it take for the Fed to hike this year if inflation has come down like we've seen?

**Michael Gapen** (3:12)
Well, I think that the answer there is that inflation wouldn't come down in line with our expectations. So if the view is that energy prices, tariffs and shelter inflation should provide plenty of offset and bring inflation down, I think the answer is you don't get payback.
Explicitly, core goods prices stay elevated. Maybe we get ongoing disruptions in the Middle East that push energy prices higher and create second round effects. So I think inflation just lingering at elevated levels could mean the Fed gets brought in to raise rates in September or later this year. We think if they're patient enough, they'll see enough disinflation to keep them on the sidelines, but the risk is this inflation forecast is too optimistic, inflation stays firm, the Fed needs to raise rates.

**Seth Carpenter** (4:01)
All right, Jens, what about for you and the ECB? They've already raised interest rates once this year. I think you've got a forecast for them raising interest rates again in September.
What could make you wrong about that forecast? What's going to make you convince that you're right about that forecast? And is there a similar tension that the ECB is wrestling with that Mike talked about for the Fed?

**Jens Eisenschmidt** (4:22)
Yeah, I mean, starting with the last part of your question, I think no doubt very similar tension, just that of course it's less obvious. It's essentially a nuanced European version instead of the loud American version that we always stereotypically think the world looks like. So essentially, we have here clearly not an AI boom.