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To Wall Street, it's 'when', not 'if' the US Fed will cut rates

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A meeting between Mr Trump and Mr Xi at the G-20 is seen as critical to the trajectory of the US-China economic dispute.

New York

THE US economy is showing signs of cooling, and Wall Street is counting on Jerome Powell, the chairman of the Federal Reserve, to come to the rescue.

The big question facing the Fed is when - not whether - to act, as far as investors are concerned.

But the Fed faces a tricky balancing act as it tries to parse economic data that are routinely complicated by US President Donald Trump's unpredictable policies.

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Mr Powell signalled last week that policymakers were ready to help prop up the economy should mounting risks from Mr Trump's continuing trade battles and slowing global growth hit the US economy. The jobs report last Friday showed that gains slowed sharply in May, prompting Fed watchers to expect rate cuts sooner rather than later.

Just last month, Fed officials agreed to leave rates unchanged as Washington's trade war with China seemed on the brink of being resolved. But Mr Trump renewed his fight just days after that April 30 and May 1 meeting, raising tariffs on US$250 billion of Chinese goods and threatening to tax nearly every Chinese import. China has since retaliated with higher tariffs on US products.

Those actions rattled financial markets and were compounded late last month by Mr Trump's threat to impose tariffs of up to 25 per cent on Mexican imports. But Mr Trump said last Friday that the tariffs would be postponed indefinitely after the Mexican government agreed to help curb illegal immigration into the United States.

The president's penchant for waging economic wars with other countries puts the Fed in a tough spot as it tries to keep employment high and inflation low. The Fed, which has struggled with persistently low inflation despite a strong job market, indicated earlier this year that it was done raising rates regularly after increasing them nine times since 2015 and that it would take a wait-and-see approach to any additional changes.

Markets now expect the Fed to cut rates - and soon. A rate cut by the end of July was 83 per cent priced into futures markets when they closed on Friday, just before Mr Trump's tweet announcing the Mexican deal. That was up from 20 per cent a month ago.

The Fed will next meet on June 18 and 19 in Washington, but it may not be prepared to act that quickly. In part, that is because officials must observe a premeeting quiet period that began on June 8 - meaning that they could not give speeches to signal to the public that a cut was imminent and would risk surprising markets if they moved quickly.

A bigger factor that could delay a cut is an expected meeting between Mr Trump and Chinese President Xi Jinping at the Group of 20 meeting in Japan this month. That meeting is seen as critical to the trajectory of the economic dispute, and could determine whether the two sides can reach an agreement. Mr Trump is expected to decide after that meeting whether to impose additional tariffs on China.

FINGER ON THE TRIGGER

That leaves the Fed's July or September meetings as more likely candidates for the Fed to act on rates.

Fed policymakers could use the June meeting "to signal that their finger is on the trigger," said Michelle Girard, chief US economist at NatWest Markets Securities, who expects cuts to start in September.

"The hurdle to cut is pretty low," she said. "You go back to a risk-management approach, and the cost of cutting rates and being wrong is not nearly as high as the risk of not cutting and being wrong."

Employers added just 75,000 jobs in May, and downward revisions to the prior two months of data left the three-month trend at 151,000 - down sharply from readings that averaged above 200,000 last year.

While the Fed has been expecting job gains to slow for some time given the low unemployment rate, underlying details of the report suggest that the pullback comes from economic softness, not just from a lack of available workers.

Wages are a big source of worry. They climbed just 3.1 per cent in the year till May, slowing for the third straight month and missing analysts' estimates. If employers were fighting for a finite pool of labour, they would, in theory, be bidding up compensation.

"The trade uncertainty might be pushing firms to hold off investment for the time being," said Ernie Tedeschi, policy economist for Evercore ISI. "They want to see what goes on with trade." Mr Tedeschi said that the risk, though it is not the most likely case, is that the slowing job market is a signal that a recession is coming. "What I hope is not happening, but we have to keep the option open, is: Is this the beginning of the end?" he said.

If pay gains do not accelerate, it means that they will never touch the 3.6 per cent year-on-year increases achieved in June 2007, the highest rate of the last expansion. That would be a significant shortfall, given that this economic expansion is set to be the longest on record as of July and was marked by major fiscal stimulus in the form of Mr Trump's tax cuts and additional government spending. Growth in average hourly earnings peaked at 3.4 per cent in February after growing tepidly for years.

Anecdotal evidence suggests that some of the recent labour market cooling is related to the trade uncertainty. Many companies in a Fed survey of businesses reported that they were holding off on hiring and expansion plans as they waited to see how the tariff tensions played out. And initial jobless claims have remained low, which suggests that companies are not firing workers - they just are not adding new ones.

Against that backdrop, the outlook for the economy could improve with the removal of tariff threats. And the unemployment rate in May held steady at 3.6 per cent - nearly a 50-year low - while a more comprehensive gauge of underemployment actually edged lower. So while there are signs of softening, the labour market is still strong.

But slowing progress in hiring paired with already-weak inflation could create a rationale for Fed action. The central bank's whole job is to foster the conditions necessary for full employment and stable price gains.

FALLING SHORT

The Fed was already falling short on half of that mission. It defines price stability as 2 per cent inflation, but price gains have consistently fallen beneath that target. The Fed's preferred index climbed just 1.5 per cent in the year till April.

Now, the second half of the Fed's mandate could be imperiled if the economic uncertainty drags out, putting corporate expansion and hiring plans on ice, and the overall economy slows.

Mr Powell's colleagues - including the president of the Federal Reserve Bank of New York, John Williams; the Fed's vice-chairman, Richard Clarida; and the Fed governor, Lael Brainard - have echoed his pledge to act as necessary to keep the economy on track and achieve their goals.

"My baseline is a very good one, but at the same time we obviously, as always, need to be prepared to adjust our views on what's happening with the economy and where the economy is likely going to go," Mr Williams said last Thursday.

Economists at Barclays said that a 0.5 percentage point move in July is now their most likely scenario, followed by a 0.25 percentage point cut before the end of the year.

"We now expect the Fed to initiate a precautionary rate cut cycle," Barclays economists Michael Gapen and Jonathan Millar wrote in a note to clients after the employment numbers were released last Friday. "We expect the committee to give a heavy nod to downside risks in the June statement, signalling to markets that they are closely monitoring incoming data and that they stand ready to provide policy support as necessary," they said.

Mr Gapen said that the call was based on economic fundamentals - incoming data on manufacturing production, business sector spending, durables orders and capital goods imports have all weakened - and did not change on news of the deal with Mexico.

Rate cuts would come at a cost, though. For one thing, they risk enabling further trade tensions. Stock prices soared on the bad-news jobs report, as investors took it as a sign that the central bank would move. Because Mr Trump closely watches the market, such a rally could leave him feeling less pressure to reach a quick deal with China.  NYTIMES