Trade tensions may steer Fed towards monetary easing

Five things to watch out for in pivotal week

Federal Reserve chairman Jerome Powell has set the stage for a possible rate cut.

Federal Reserve chairman Jerome Powell has set the stage for a possible rate cut.

 

Federal Reserve policymakers are set to meet on Tuesday and Wednesday for a gathering that is laden with anticipation because of the possibility that chairman Jay Powell could start steering the US central bank towards monetary easing.

Few economists expect the Fed to cut interest rates from their current level of 2.25-2.5 per cent, but they do believe Mr Powell and his colleagues on the Federal Open Market Committee (FOMC) could send strong signals about the conditions under which they might do so later in the year.

In the run-up to the meeting, Fed officials have suggested they were ready to act to sustain the economic expansion due to the growing risk of damage from President Donald Trump’s trade policies. But the case for such a move is hardly a slam dunk, with unemployment at record lows and few signs that a serious downturn or recession is around the corner. Here are five things to watch in a pivotal week for the Fed.

Tracking the dots

The Fed is keen to point out that the direction of monetary policy should not be deduced from its economic projections, which are released at every other FOMC meeting. But analysts and investors will nonetheless pay close attention to the so-called dotplot – in which individual Fed officials map their forecasts for interest rates.

In December, they were projecting two interest rate increases this year. But by March, they were forecasting none this year, and just one in 2020, as Mr Powell slammed the brakes on his tightening cycle. Some Fed officials will almost certainly chart interest rate cuts this year at the June meeting, completing the shift. The question is whether the median forecast will be one notch lower than it is today, or more.

Weighing the trade wars

When FOMC officials last met in early May, they were already paying close attention to trade as an important risk factor for the US economy. But that concern was expressed carefully in their statement.

The Fed referred to “global economic and financial developments” as a factor driving its neutral monetary policy, but did not single out trade. Since then, US talks to end the trade war with China have broken down, leading to an escalation of tariffs and other moves aimed at decoupling the two economies.

Mr Trump also threatened new levies on Mexico and kept an old threat of car tariffs alive to the detriment of the EU and Japan. If Fed officials are growing increasingly concerned about the trade wars, they may have to use more explicit language.

Patience wears thin

Early this month Mr Powell set the stage for a possible rate cut at a Fed conference in Chicago, in which he cited the uncertainty over trade negotiations and said the central bank was ready to act to sustain the expansion. But having sent that signal, he now faces the challenge of reinforcing it, or pulling back, depending on the conclusions reached by Fed officials.

In the last FOMC statement, officials said the committee would be “patient as it determines what future adjustments” would be made to interest rates. If they no longer use the word patience, it could indicate they are preparing to make a move. But if they keep it, it might point to greater caution.

Beating inflation

Aside from trade uncertainty, the other big rationale for an early rate cut comes from stubbornly subdued US inflation, which has failed to hit the central bank’s 2 per cent target despite relatively strong growth and historically low unemployment. The data have not shifted significantly on inflation in recent weeks, so the language in the statement might not change.

However, in his press conference Mr Powell will almost certainly have to explain whether he sees the low price pressures as a temporary factor, or a more long-term fault in the economy that requires correction.

Handling the bond markets

In addition to Mr Trump, Mr Powell is facing pressure to cut rates from bond investors who have bet heavily on a new easing cycle, driving Treasury yields sharply lower.

The Fed chairman has had a few communications mishaps that have caught markets off-guard since taking the post in early 2018, and will want to avoid another one this week, so simply restating that the central bank will take action depending on the data may not be sufficient.

He will also not want to promise a future easing that may never take place. After markets offer their initial reaction to the FOMC’s statement and projections, Mr Powell may have to adjust their expectations in his news conference. – Copyright The Financial Times Limited 2019