The Federal Reserve is shifting from the driving seat back to the back seat, moving to data dependence just as it faces a data blackout due to the government shutdown. Despite these challenges, Morgan Stanley believes rate cuts in December and January remain on the table as the softer labor market will continue to drive monetary policy.

The shutdown has suspended several official data releases, including critical jobs reports, leaving the Fed to rely more on market signals and private sector data. "The Fed is effectively flying blind for now," Morgan Stanley economists said in a recent note, emphasizing how this unusual backdrop complicates monetary policy decisions.

Market expectations, inflation moderation, and ongoing economic growth risks, however, keep rate cuts on the table later this year and into early 2026, the economists said. "We acknowledge uncertainty increases with the shutdown but see December and January rate cuts priced in and plausible," they added.

Morgan Stanley acknowledged the risks around its ongoing call for a December and January rate given Powell's warning on Wednesday that a further rate cut in December "is not to be seen as a foregone conclusion. In fact, far from it." The somewhat hawkish remarks from Powell arrived on the heels of the Fed's second rate cut of the year on Wednesday.

"Given Chair Powell's comments around potentially slowing the pace of policy changes due to lack of data, a prolonged shutdown is a risk to this view," Morgan Stanley said

In this environment of uncertainty, Morgan Stanley suggest investors should expect volatility in response to new data releases and shifts in financial markets as the central bank recalibrates its path amid the shutdown-related blind spot.

Against the backdrop of uncertainty and the move back from the Fed to data dependence for monetary policy decisions, the dollar is likely to shine, albeit in the near term, the economists said.

"Our FX strategists see scope for a near-term USD rebound...although they still expect a medium-term USD decline driven by yield compression, lower real rates, and a fading US growth advantage into 2026," Morgan Stanley said.

Source: Investing.com