I've just looked at my grub.cfg file, and it's very nearly the same as yours, but there's a small difference. I don't know if it's significant, yours says set root='(hd0,msdos1)', while mine says set root='(/dev/sda,msdos1)'. sda and hd0 are the same thing, a reference to your hard drive, so not important (I think). But what could be significant is the lack of /dev/. The root is on a device (ie your hard drive) so the full address of that device is /dev/hd0,msdos1.
Can you try editing that line and see if that works. I'm not sure if the edit is persistent, so you may need to do some more editing once you have an operating system. sudo update-grub might do it.
let us know how you get on, regards
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