Trump’s immigration crackdown may unexpectedly push Fed into steeper rate cuts: MS

Morgan Stanley analysts suggest that the Trump administration's restrictive immigration policies, unlike its legally challenged trade tariffs, are significantly impacting the labor market and potentially influencing future Federal Reserve policy. The analysts have cut their immigration outlook to 800,000 this year and 500,000 next year, anticipating slower population and labor force growth, which could lead to a tighter labor market and prompt the Fed to cut rates more aggressively than expected, potentially reaching a policy rate trough of 2.50–2.75% in 2026. This is due to a lower potential growth rate translating into a lower neutral interest rate.

Analysis

Morgan Stanley highlights that the U.S. administration's restrictive immigration policy is a significant and relatively certain factor shaping the economic landscape and potential Federal Reserve actions, contrasting with the ongoing legal uncertainties surrounding trade tariffs. The firm has consequently lowered its immigration outlook to 800,000 individuals for the current year and 500,000 for the next, anticipating this will lead to a deceleration in population growth to 0.4% in 2025 and 0.3% in 2026, and a slowdown in labor force growth to 0.7% this year and 0.5% next year. This scenario is expected to result in a persistently tight labor market, even if employment growth slows, as diminished labor supply rather than weak demand would be the primary driver. Morgan Stanley projects that this dynamic will reduce U.S. potential economic growth to 2.0%, and potentially as low as 1.5% next year, thereby exerting downward pressure on the neutral interest rate. This assessment underpins their forecast for the Federal Reserve to implement more substantial rate cuts once an easing cycle commences, potentially bringing the policy rate to a trough of 2.50–2.75% in 2026. While trade tariffs associated with the Trump administration face legal challenges, Morgan Stanley anticipates that much of the current tariff structure could be reinstated through other legal avenues, leading to gradual tariff escalation in 2025 and early 2026, which would further dampen economic activity. Recent economic indicators, such as the revised 0.2% quarter-on-quarter decline in Q1 GDP and a slowdown in personal consumption, alongside labor market data showing reduced hiring but no collapse in demand, align with this outlook of gradual economic cooling influenced by these policy measures.

Key Decisions for Investors

• Investors should consider the possibility of a more accommodative Federal Reserve policy stance than currently anticipated, driven by the structural economic impacts of reduced immigration on labor supply and potential GDP, which could lead to deeper interest rate cuts.
• Closely monitor labor market data, particularly indicators of labor tightness stemming from constrained supply due to immigration policies, as this will be a critical determinant of the Federal Reserve's assessment of economic conditions and its policy path.
• Evaluate portfolio allocations in light of the combined economic headwinds from restrictive immigration policies and potential tariff escalations, which Morgan Stanley suggests will slow economic growth, paying particular attention to rate-sensitive assets and sectors reliant on domestic labor.