HIGHLIGHTS OF THE WEEK
- A potential trade war between U.S. and Mexico was averted, but global trade uncertainty remains.
- Despite markets pricing in rate cuts, domestic indicators suggest that the U.S. economy is on decent footing. Inflation remains stubbornly low, however.
- The Fed rate decision next week is clouded by conflicting signals, but we believe it will likely feature an easing bias.
Conflicting Signals Cloud Fed Rate Decision
The U.S. economy is taking us on a bit of a rollercoaster ride. Some signals suggest that the downside risks to growth are rising, necessitating further support by the Federal Reserve. Others indicate that the economy is doing just fine, and stepping on the gas might not be warranted. One thing’s for sure, the Fed has a tricky path to navigate as it seeks to sustain the economic expansion.
This week was a perfect example of the conflicting signals faced by the economy. We began the week with a quick extinguishing of a possible trade war with Mexico, but trade uncertainty still looms large. Indeed, the trade conflict between the U.S. and China is not subsiding. Earlier this week, President Trump warned that if President Xi did not meet with him at the upcoming G20 summit, he would immediately slap 25% tariffs on the remaining un-tariffed $300 billion of Chinese imports.
Markets are pricing in the risks emanating from the trade conflicts, resulting in a continued inversion of the yield curve (3-month to 10-year), and an expectation of at least two Fed rate cuts by the end of the year.
However, trade uncertainty does not yet seem to be weighing on business optimism. The NFIB small businesses optimism index improved for the fourth consecutive month as businesses anticipated an improvement in economic conditions and more capital expenditure in months to come.
Moreover, U.S. consumers displayed their strength again, with solid retail sales growth in May alongside a significant upward revision to April data (Chart 1). Consumption growth may now exceed the 3% (annualized) mark in Q2.
Despite the strength in consumption, CPI inflation weakened in May. The weakness in inflation in Q1 appears now to be less transitory. Core inflation declined for a range of products including used cars and trucks, apparel, and motor vehicle insurance. While inflation may pick-up going forward, given the increased tariffs on Chinese imports, underlying price pressures in the economy seem to be limited.
The Fed will no doubt take notice of the weakness in inflation in the FOMC meeting next week. But they will also have to consider all other developments as well. Despite rising downside risks, the domestic economy appears to be chugging along. All told, we expect the Fed to convey an easing bias, but not move on rates at next week’s meeting.
We also saw a rise in global political risks rise this week as two oil tankers were attacked in the Gulf of Oman. After falling through much of the week on the back of concerns about global growth, Brent oil prices jumped by around 5% on Thursday (with a similar move in the WTI contract), not quite enough to offset losses earlier in the week (Chart 2). With the relationship between the U.S. and Iran increasingly strained, oil markets may get caught in the middle.
Sri Thanabalasingam, Economist | 416-413-3117
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