Morgan Stanley's Michael Gapen Says Fed Is Not ‘Out Of The Water’ Even With A Hold Decision: ‘Economy Can Handle 75-100 Bps In Total Hikes’

Morgan Stanley’s chief U.S. economist Michael Gapen told CNBC that while the Federal Reserve will hold rates in October, markets should expect the policy rate to rise in the future.

• According to data from the CME FedWatch tool, markets are placing the odds of a ‘Hold’ decision at 88.9%, significantly up from 35.8% a month ago.
• Meanwhile, the probability of a rate hike of up to 50 bps is 81.6%, according to the website. 
• Gapen believes the Fed will cite a wait-and-see approach, adding it will watch underlying trends to assess where policy may ultimately go. 

The Federal Reserve is set to meet for its October policy decision on Tuesday, with markets overwhelmingly expecting the central bank to hold rates steady after a 25-basis-point hike at its previous meeting. 

Morgan Stanley’s chief U.S. economist Michael Gapen agrees with the market, saying that while the Fed will hold rates in October, markets should still expect the policy rate to rise later.

In an interview with CNBC, Gapen said that even if the Fed holds rates steady this month, “the Fed's (not) out of the water by any means,” adding that he doesn’t “think they (the Fed) think that” either. 

How The Fed May Justify Holding Rates

Gapen believes the Fed will cite a wait-and-see approach, saying it will watch underlying trends to assess where policy may ultimately go. 

“So I think that's the balance. They stay on hold,” but with the expectation of policy rates going higher in the future. 

According to data from the CME FedWatch tool, markets are placing the odds of a ‘Hold’ decision at 88.9%, significantly up from 35.8% a month ago. Meanwhile, the probability of a rate hike of up to 50 bps is 81.6%, according to the website. 

Gapen thinks the central bank could argue that it will choose how to validate the market’s financial conditions that are tightening. He said, “One argument against going at successive meetings would be the risk of causing too much tightening in financial conditions.” 

However, he added that there are risks to whichever way the Fed goes, but it would likely take a “more gradual pace.” 

Gapen Believes Markets Can Handle Up To 100 Bps Hike ‘Without Concerns’

The economist agreed that the war in the Middle East and rising oil prices would pose a risk to inflation, adding that Morgan Stanley is “factoring some of it into our inflation forecast next year” and that the Federal Open Market Committee will likely consider it as well. 

The bigger question is whether the central bank can afford to hike benchmark interest rates every other meeting and assess data as it comes, adding that energy markets will likely dictate that course. 

“I think it's right to think the economy can handle 75 to 100 basis points in total hikes without, without, say, a tremendous amount of concern,” about impact on yields, Gapen said, but cautioned that if the Fed needs to do six or seven total hikes to get back to 2023 levels, then it could cause some concerns. 

How Are Markets Reacting Now?

At the time of writing, the SPDR S&P 500 ETF (SPY) was down about 0.05% in the overnight session amid ‘bearish’ sentiment. The Invesco QQQ Trust (QQQ) was down 0.36% at the time of writing, while the SPDR Dow Jones Industrial Average ETF Trust (DIA) was up 0.16%. 

Meanwhile, the iShares 20+ Year Treasury Bond ETF (TLT) was up 0.21% amid ‘neutral’ sentiment. 

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