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Investing.com - A deterioration in the labor market that extends beyond government and manufacturing and into the key services sector could persuade the Federal Reserve to slash interest rates by the end of this year, according to analysts at Morgan Stanley (NYSE:MS).
However, in a note, the analysts led by Michael Gapen said they still anticipate that the central bank will leave rates unchanged for the remainder of 2025.
The Fed is set to kick off its latest two-day gathering on Tuesday, with policymakers widely projected to keep borrowing costs steady at the end of the meeting. Many officials have backed a wait-and-see attitude to future rate actions, citing uncertainty around the impact of U.S. President Donald Trump’s aggressive tariff agenda on the wider economy.
But the Morgan Stanley strategists suggested that more impetus for a cut could come from a sharp drop in U.S. payrolls of 50,000 or more per month, "centered in services." The services sector is major driver of the broader economy, accounting for more than two-thirds of overall activity.
A bevy of labor market data is due out this week, including the all-important monthly jobs report. Economists project that the U.S. added 108,000 roles in July, down from 147,000 in the previous month.
Unexpected immigration changes could also lead the Fed to roll out earlier rate reductions, the Morgan Stanley analysts predicted. Although they anticipated that stronger immigration controls will sharply curtail growth in the labor force, the brokerage noted that the projection could be proved wrong if there are more undetected border crossings than they expect. This could support participation in the labor market, bolstering the case for a Fed cut.
Another scenario revolves around disinflation in the services sector, which could offset an upward impulse on prices from tariffs, the analysts noted. This may give the Fed more confidence that trade-related inflationary pressures are "transitory," they added.
The argument for a rate drawdown by December could also be boosted by a "low, but elongated" pass-through of tariff costs to consumers from companies that leaves the Fed’s preferred inflation metric at between 2.6% to 2.8% year-over-year, they said.
Should firms opt to absorb tariff expenses, and subsequently post more negative earnings that dent share prices, a Fed cut may also come sooner than anticipated, the analysts said.