A new note from Morgan Stanley is pushing back against the Federal Reserve’s 2026 rate-cut outlook, warning that a hawkishpivot by global central banks and not economic weakness is now the biggest risk to markets.
In the wake of last week’s Federal Open Market Committee meeting where policymakers held interest steady, Morgan Stanley said investors may be underestimating how firmly the Fed is prioritizing inflation over growth.
That shift, reinforced by rising oil prices tied to the Iran war, has already reshaped market expectations with traders increasingly pricing out rate cuts and even assigning odds to future rate hikes.
The result: a sharp tightening in financial conditions, according to Morgan Stanley.
- Bond yields have climbed.
- Equity valuations have compressed.
- The long-dormant negative correlation between stocks and interest rates has reemerged. This is a signal that higher rates are once again a headwind for equities.
For investors hoping that the Fed’s latest “dot plot” signals eventual easing, Morgan Stanley’s message is clear that that path depends on a reversal in U.S. central bank hawkishness.
“The final hurdle for this correction may well have nothing to do with the war or oil; instead, it may be in the hands of central banks, who have all seemingly pivoted more hawkish on concerns about inflation taking precedent over growth,’’ the note said.
Until then, markets remain vulnerable to volatility, policy missteps, and the risk that inflation (and not growth) will dictate the trajectory of interest rates, Morgan Stanley explains.
Federal Reserve eyes inflation risk from Iran War
The FOMC 11-1 vote to hold interest rates steady at 3.50% to 3.75% underscores the central tension now driving U.S. monetary policy.
Investors are no longer debating whether risks to the Fed’s dual mandate exist, but which risk matters more to the U.S. economy.
On one side, inflation remains stubborn. Producer prices came in hotter than expected March 18, showing an acceleration that began before the Iran strikes.
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The risk? Inflation could reaccelerate rather than continue its slow drift toward the Fed’s 2% target.
In addition, economic drive is also showing signs of weakness. The softening labor market and slowing growth would typically prompt interest-rate cuts.
This was a path markets had been expecting just a few weeks ago at the Fed.
Federal Reserve Bank of New York via FRED®
Iran war ignites U.S. stagflation concerns
The Iran war, by driving energy costs sharply higher, has reopened the traditional stagflationdilemma of rising prices alongside slowing growth.
In its March 18 press release, the FOMC said available indicators suggest that economic activity has been expanding at a solid pace.
“Uncertainty about the economic outlook remains elevated. The implications of developments in the Middle East for the U.S. economy are uncertain,’’ the release said. “The Committee is attentive to the risks to both sides of its dual mandate.”
What the Fed dual mandate requires for jobs, prices
The Fed’s dual congressional mandate requires it to balance full employment and price stability.
- Lower interest rates support hiring but can fuel inflation.
- Higher rates cool prices but can weaken the job market.
The two goals often conflict, operate on different timelines and are influenced by unpredictable global events such as pandemics and wars.
Even before the outbreak of the Iran war, the Fed faced a dilemma from worrisome risks to both sides of its congressional mandate: higher unemployment rates and sticky inflation.
Fed Chair Jerome Powell told reporters after the March 18 FOMC meeting that the economy was settling into a moderately neutral range.
A neutral range for economists means monetary policy is neither stimulating nor restricting economic growth.
“Chair Powell was indeed perceived by the market to be on the hawkish side as the Fed appears to be prioritizing inflation risks more than growth risks,’’ Morgan Stanley wrote.
Fed’s 2026 forecast on interest rates unchanged
The Fed’s March median Summary of Economic Projections or “dot plot” calls for a single quarter-point rate cut in 2026, and an additional quarter-point cut in 2027, the same as the December 2025 forecast.
But Powell noted in his press conference that the rate cut was not guaranteed, especially if the projected decrease in inflation doesn’t occur.
Related: Fidelity delivers sobering interest-rate message amid Fed pause
“While the Fed didn’t take rate cuts completely off the table, the rates market did,’’ Morgan Stanley wrote.
“Powell’s focus on inflation risk and similar concerns from other central banks this past week to bond market pricing to a 40% chance of a Fed rate hike by October.”
Traders mull rate-hike odds
The CME Group FedWatch tool is calling for a 10.6% chance of a quarter-point rate hike at the Fed’s April 29 FOMC meeting.
Additional FedWatch rate-hike forecasts as of March 24:
- June 20.2%
- July 25.8%
- September 34.1%
- October 39.4%
- December 34.6%
Chicago Fed’s Goolsbee outlines interest-rate scenario
Federal Reserve Bank of Chicago President Austan Goolsbee said March 23 in a CNBC interview that he could envision the U.S. central bank needing to raise interest rates, or returning to rate cuts, depending on how the Iran war plays out.
“We could be back to the environment with multiple rate cuts for the year if inflation behaves,” Goolsbee, who is not a voting member of the FOMC this year, said.
“I could see circumstances where we would need to raise rates if it was going a different way, and inflation was getting out of control,’’ he added.
Fed’s Miran sticks to four rate cuts in 2026, for now
Federal Reserve Governor Stephen Miran said the central bank shouldn’t set policy based on short-term considerations related to the Iran War.
“We should wait for all the information to come in before really changing our outlook,” Miran said Monday in an interview on Bloomberg Surveillance March 23.
“And I think it’s just still premature to have a clear view about what this is going to look like as you look 12 months out,” he added.
Miran said his pre-war outlook for four quarter-point rate cuts this year remains intact, but he acknowledged that the risk of oil prices remaining high could bleed into other goods and services.
Investors face clouded interest-rate outlook
For investors, the message is increasingly clear that the path to lower interest rates in 2026 is no longer guaranteed.
Unless inflation pressures ease or financial conditions deteriorate sharply, the Federal Reserve may stay hawkish for longer than expected at the start of the year.
That leaves markets navigating a narrow path where policy missteps, persistent inflation, and geopolitical shocks could define the next phase of monetary policy.
Related: J.P. Morgan pushes back on Fed’s 2026 rate-cut forecast