A Narrower Path for Growth and Stability

Higher rates can take time to filter through the economy, making their full impact difficult to judge. Arunima Sinha from our U.S. and Global Economics teams considers where the pressure may emerge next and how policymakers could navigate the competing risks.Read more insights from Morgan Stanley.----- Transcript ----- Welcome to Thoughts on the Market. I'm Arunima Sinha, from the Morgan Stanley’s U.S. 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 10am 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 U.S. 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 U.S. so far, even the most recent upside inflation surprise pointed to resilient demand rather than energy-driven stagflation