Losing Patience?

While the federal funds futures market is pricing in some chance (about 24%) of a rate cut this week, the Federal Open Market Committee is widely expected to leave rates steady. The market currently see a stronger probability (about 87%) of a July 31 rate cut, although that is subject to change depending on what the Fed says this week. Future policy action will remain data-dependent, but the FOMC policy statement, the revised Summary of Economic Projections (SEP), and Chair Powell press conference will set market expectations. Over the last several months, stock market participants have been hyper-sensitive to minor changes in the policy outlook.

At this point, the U.S. economy does not appear to be heading into a recession. The underlying trend in job growth has remained strong, although slower than last year (the “disappointing” 75,000 increase in nonfarm payroll in May was noise). The unemployment rate is 3.6% (2.9% for prime- age workers), the lowest in 50 years. The May retail sales data were consistent with a pickup in consumer spending growth in 2Q19 (not much of a stretch following the subpar results of the first quarter).

However, the recent economic data do not fully reflect the impact of the May 10 escalation in tariffs (the 10% tariff on $200 billion in Chinese goods was raised to 25%). A 10% tariff can be partly offset through a weaker currency (the yuan has fallen a little over 8% against the U.S. dollar over the last year), but a 25% tariff will be hard to avoid. Some production can move to other countries (Vietnamese trade is expanding rapidly), but a lot of that will take time. Moreover, the uncertainty is keeping a lot of international businesses back on their heels, reluctant to make capital expenditures. The government and the People’s Bank of China can be expected to pull out all the stops to keep the country’s economy growing strongly, but foreign trade disruptions will still be felt. China imports a lot of supplies and materials from the rest of the world. Those countries are hurting, adding to global economic weakness.

Global economic weakness appears to be putting downward pressure on commodity prices. Although they do not directly reflect tariffs, the producer price data show a decrease in pipeline inflation pressures in recent months. Most (63%) of the Consumer Price Index is services. The core CPI rose 2.0% over the 12 months ending in May, but the Fed uses the PCE Price Index for its inflation target – and year-over-year increase in the core PCE Price Index has been trending about 0.4 percentage point below the core CPI. The Fed has consistently undershot its 2% target, and recent figures ought to provide the central bank some cover to cut short-term interest rates.

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It’s hard to argue that the current federal funds target range (2.25-2.50%) is all that restrictive. However, anecdotal information suggests that businesses are feeling a greater impact from tariffs. The May 10 increase in tariffs has further disrupted supply chains and dampened business confidence. The drag on the economy is much larger than the tariffs that came before, but not (by itself) enough to push the U.S. economy into a recession. However, President Trump has threatened to impose a 25% tariff on the remaining $300 billion or so in Chinese goods, mostly consumer goods. This would likely double the economic drag from tariffs, putting the economy on the cusp of a recession.