June 19, 2019 / 10:06 PM / a month ago

What changed for the Fed in seven weeks? Trade risks top the list

(Reuters) - On May 1, the Federal Reserve viewed the American economy as having a solid footing and risks to the outlook were muted.

Federal Reserve Chairman Jerome Powell holds a news conference following a two-day Federal Open Market Committee meeting in Washington, U.S., June 19, 2019. REUTERS/Kevin Lamarque

That assessment has weakened demonstrably since, and Fed Chair Jerome Powell and many of his colleagues inside the U.S. central bank on Wednesday signaled readiness to cut interest rates as required to shore up a U.S. economic expansion that appears to be losing steam.

What exactly changed in seven weeks to alter the outlook so much?

TRUMP’S TRADE DISPUTES ARE WEIGHING

America’s trade relationship has grown more strained in recent weeks with China and Mexico, two of the United States’ top trading partners. When the Fed held its April 30-May 1 meeting, Washington and Beijing appeared to be closing in on a trade deal that would avoid an escalation in the trade war between the two countries.

That changed on May 5, when President Donald Trump unleashed an angry barrage of tweets, complaining that China had reneged on promises it had made in the talks and threatening to ratchet up tariffs on Chinese goods.

The negotiations unraveled and Washington hit China with higher tariffs on some $200 billion worth of goods on May 10, prompting China to retaliate. Washington is also threatening tariffs on another roughly $300 billion in Chinese imports if the two sides don’t reach a deal soon, with Trump and Chinese President Xi Jinping expected to meet at a Group of 20 summit in Japan next week.

Trump then turned his sights on Mexico, and on May 30 he threatened new tariffs on all Mexican imports if America’s southern neighbor did not do more to stop the flow of migrants across the U.S border. While the two sides reached a deal June 7 to avoid the tariff hikes, Washington says it could still impose tariffs if Mexico does not follow through on commitments on immigration matters.

In a survey the Fed conducts with its business contacts across the country before each meeting, companies reported they were increasingly concerned about the trade environment, and that was before events with Mexico escalated.

During his press conference after the meeting, Powell also cited trade as a primary culprit for increased uncertainty.

“News about trade has been an important driver of sentiment in the interim,” Powell said.

BUSINESS INVESTMENT IS SOFTENING

Business spending, which braked sharply in the first quarter to the slowest pace during Trump’s tenure, is showing signs of further weakness in the second quarter, with new orders for U.S.-made capital goods falling more than expected in April, data that was not published until late May.

Though only 12% of the economy, spending by business on equipment and factories is a key signal for the staying power of economic growth.

“While the baseline outlook remains favorable, many FOMC participants cited the investment picture and weaker business sentiment ... in supporting their judgment that the risk of less favorable outcomes has risen,” Powell said, referring to the policy-setting Federal Open Market Committee.

A range of surveys of U.S. manufacturing activity show growth has declined to levels not seen in years.

INFLATION REMAINS WELL BELOW TARGET

Inflation has shown no signs of rising toward the Fed’s targeted level of 2%, and Powell noted that measures of inflation expectations - important factors guiding the behavior of consumers and businesses - have softened.

Expectations for future inflation embedded in U.S. Treasury Inflation-Protected Securities, or TIPS, have tumbled since May 1 and this week hit their lowest in nearly three years.

Survey-based measures of the inflation outlook have been more stable but some, such as the New York Federal Reserve’s monthly reading of consumers’ inflation expectations, are the lowest since late 2017.

NOT EVERYTHING HAS GONE SOUTH

While trade friction and a manufacturing slowdown are big risks, it is consumer spending that accounts for more than two-thirds of economic activity.

And the Fed is still getting some good news about the U.S. consumer.

Since the central bank’s last rate-setting meeting, the Commerce Department reported that U.S. retail sales increased in May and the agency also revised sales for the prior month higher, suggesting a pick-up in consumer spending.

That makes sense in an economy giving more people work.

Despite a slowdown in hiring in May, 151,000 people per month have taken new jobs over the most recent three months. That is more than the roughly 100,000 needed per month to keep up with growth in the working-age population, recent Labor Department data show.

People are also taking home more pay. Average hourly earnings grew 3.1% year-over-year in the latest month. That figure, also reported by the Labor Department, is slower than in recent months but still supportive of more spending at restaurants and malls.

Strong spending helps the services sector of the economy, with industries ranging from education to healthcare, and activity in that area expanded at a brisk pace in May, a survey from the Institute for Supply Management showed earlier this month.

Compiled by Ann Saphir in San Francisco, Trevor Hunnicutt in New York, and Jason Lange and Dan Burns in Washington; Editing by James Dalgleish

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