Morgan Stanley stated that the data confirmed its disinflation forecast, but also noted that upside risks to inflation remain, which could impact interest rate forecasts for 2027.

According to the US Bureau of Labor Statistics, the annual growth rate of the Consumer Price Index (CPI) slowed to 3.4% in July from 3.5% in June, while the core CPI fell to 2.5% from 2.6%. Similar dynamics were observed in the Producer Price Index (PPI) in July.

The inflation data came on the heels of an unexpectedly weak July nonfarm payrolls report, and together, these indicators provide the Fed with the opportunity to keep interest rates unchanged and await further data. Investors responded accordingly, lowering their bets on a Fed rate hike in September. According to the CME FedWatch tool, the central bank's chances of holding rates unchanged next month are now around 67%, down from around 55% a week ago.

"Disinflation appears to be driven by a pullback in tariff pressures, lower energy prices (with limited spillovers), and a slowdown in housing inflation," Morgan Stanley analysts led by Michael Gapen wrote on Friday.

"The baseline scenario remains a patient Fed stance: softer inflation, coupled with a cooling labor market and slowing wage growth, should allow the Fed to keep rates unchanged through the end of the year," they added.

While CPI and PPI are widely used inflation measures, the Fed prefers to track the core personal consumption expenditures (PCE) index, which has a long-term target of 2%. Components of CPI and PPI are included in the PCE calculation. "Given the July PPI data, we now forecast core PCE inflation of 0.23% in July and headline inflation of 0.14%, representing annualized changes of 3.27% and 3.64%, respectively," the analysts said.

"If inflation follows our baseline forecast, with core PCE inflation falling to 3.0% year-on-year in December and 2.4% by the end of 2027, we project the Fed to keep rates unchanged this year and cut the policy rate by 50 bps next year (with 25 bps cuts in March and June)," they added.

The analysts also emphasized that risks to their monetary policy outlook are tilted to the upside. Their forecast assumes a full recovery from the recent supply shocks without the emergence of new shocks. Moreover, it assumes limited price pressures related to demand for artificial intelligence.

"One or both of these assumptions could prove wrong," Morgan Stanley warned.

"It's possible that inflation will decline by 2027, but not enough to justify rate cuts next year. In that case, the Fed would keep rates unchanged for the remainder of our forecast horizon. Alternatively, it's possible that the recent disinflation will prove temporary, and inflation will not decline further or even accelerate, requiring a 50-75 bps rate hike to reverse last year's risk-management rate cuts," the company noted.

"Overall, we believe the data points to a patient Fed stance. Disinflation is here. The question is how long it will last and how far it will go." We remain optimistic in this regard and expect further progress towards the 2% target in the coming months,” the analysts concluded.