The road to the Fed's official policy pivot this week to lower interest rates began in early May, with a tweet.
President Donald Trump tweeted May 5 that he could slap China with new tariffs, and that Beijing was attempting to renegotiate. That sudden escalation of the trade war surprised markets and business leaders, who were looking forward to a negotiated deal between the White House and China that would end the trade conflict and roll back tariffs, instead of increasing them
The Sunday tweet was just four days after the Fed's May meeting, where it had kept rates steady while reaffirming that it was still paused in its policy to raise interest rates. In fact, Fed Chairman Jerome Powell said that day that weak inflation was just viewed as transitory by the central bank, basically suggesting it was not reason enough to cut interest rates.
But since then, economic data, particularly in manufacturing, got softer, trade tensions escalated, China's economy continued to be weak and inflation has remained subpar. Now the Fed has officially signaled it is ready and willing to cut interest rates.
"The only thing that's really changed materially is the shot heard around the world that Sunday afternoon when Trump threatened to raise tariffs from 10% to 25% on that second tranche of Chinese imports. That's what really started the ball rolling. The market was looking for rate cuts for awhile and it really went into overdrive after the Trump trade war escalated against China," said Chris Rupkey, chief financial economist at MUFG Union Bank.
'Speed of a tweet'
Diane Swonk, chief economist at Grant Thornton, said other factors contributing to a change in tone were Trump's threat to put tariffs on all Mexican goods, which he dropped, and the fact that the global economy was not rebounding as expected. Despite stimulus, China's economy continued to be weak.
"We live in a world where policy can change in the speed of a tweet, and you can get a turn in policy in the speed of a tweet. The ability of the president to unilaterally raise tariffs in so many areas is something Congress is concerned about, but hasn't done anything on yet. It adds to the risk of a global slowdown," said Swonk.
Fed officials, by the beginning of June, had opened the door to rate cuts by saying they would take action to extend the economic expansion if necessary, and they followed that up Wednesday by signaling after their meeting that an interest rate cut could be coming as soon as July.
"Only seven weeks ago, we had a great jobs report, and came out of the last FOMC meeting feeling that the economy and our policy was in a good place. So, we want to see and we want to react to developments and trends that are sustained, that are genuine, and not react just to data points or just to changes in sentiment, which can be volatile," Powell told reporters after the Fed's meeting Wednesday.
Powell said trade has been an important driver of sentiment. "It's really that and global growth that are on our minds. So we're not exclusively focused on one event or piece of data," he said at the briefing.
The Fed on Wednesday left interest rates unchanged, but its statement, forecasts and Powell's comments signaled that the Fed was ready to cut interest rates if needed to help the economy and fight the effects of trade wars, low inflation and a global slowdown. As many as seven Fed officials forecast a half percentage point interest rate cut this year in their forecast, and Powell, during his comments, emphasized that others were leaning in that direction.
Depends on trade
"In my mind, it really boils down to the direction of trade. I think that's what Powell told us. You can see how trade has affected the U.S. economy. Fixed investment spending is about a third of what it was before the trade war," said Ward McCarthy, chief financial economist at Jefferies.
McCarthy said in the six quarters ended Q2, 2018, business fixed investment grew at an average 6% a quarter.
"Since then, it's grown over just a little bit over 1%, and it looks like it's slowing. That is directly related to the trade tensions and that is the primary economic affect the Fed is worried about," McCarthy said.
Many economists expect the Fed will now raise interest rates as much as 50 basis points at its July meeting, and some expect it even if the president can come to some compromise toward a trade deal when he meets with Chinese President Ji Xinping at the G-20 summit next week. Trump has threatened to put tariffs on $300 billion in Chinese goods if that meeting does not go well.
"If he can deliberate on a meaningful trade deal with China, the adverse effects we've seen on fixed investment spending, the adverse effects we've seen on business confidence will reverse and that should obviate the need for the Fed to act," said McCarthy. "There's kind of an irony here. Trump has been beating on the Fed to get lower rates, but it would be because he failed on trade."
The Fed, and Powell in particular, have been criticized by the president for not cutting interest rates. Trump has explored demoting Powell, but the Fed chair stressed Wednesday that the law is clear and he intends to serve out the rest of his four-year term.
Powell also said when the FOMC ended its meeting May 1, there was tentative evidence that some of the negative crosscurrents in the economy were moderating.
"The latest data from China and Europe were encouraging, and there were reports of progress in trade negotiations with China. Our continued patience stance seemed appropriate and the committee saw no strong case for adjusting our policy rate," the Fed chair said Wednesday.
Just before that early May weekend tweet, the S&P 500 had hit an all-time high on the previous Friday, after a report that the economy had added 263,000 jobs in April.
That report has since been revised slightly lower, but was followed by May's dismal nonfarm payrolls of just 75,000, a slowing that many economists blamed on the trade wars. The S&P 500 on Thursday finally surpassed that record set May 3, as the market rallied on expectations for an interest rate cut. Treasury yields also slid since then with the 10-year reaching a low of 1.97% on Thursday, from a high of 2.5% on May 3.
"The interesting thing to me is the China trade war accelerated the downward slide in yields. What if there is a settlement with China? The Fed's really painted themselves into a corner here where they pretty much have to deliver what the market wants," said Rupkey. "If G-20 goes well, the Fed will call it an insurance rate cut, just in case."
Recession-like data?
Rick Rieder, BlackRock's CIO of global fixed income, said on CNBC Thursday that he expects a 50 basis point rate cut, citing the potential for some upcoming data to look recession-like, after a slowdown in manufacturing activity. He said the Fed's pivot was expected, and it is the second of the year after the central bank shifted out of rate hiking mode in January. The Fed had downshifted to neutral, its last interest rate hike in December, and a turbulent market sell-off.
"[Wednesday's] policy moves from the Federal Reserve largely met market expectations and began a transition toward the third stage of a three-part rate cycle story for 2019. The year started with rates moving higher following the ill-advised December rate hike by the FOMC, yet that move was soon (and dramatically) terminated in January, in what we had long argued would be a very prudent change in policy direction, as the Fed paused its rate hiking cycle," Rieder wrote.
"The rate cycle has clearly entered a new phase of easier policy alongside of some clear global economic weakness, some softening of conditions in the U.S., some heightened trade/political uncertainties and an inflation dynamic that is not moving closer to the Fed's 2% target, and indeed, by some measures, has recently been moving further from it," Rieder noted.