Escalating trade spats between the U.S. and other countries are increasing the chatter that the Federal Reserve will cut interest rates this year instead of staying on hold.
For months, futures markets have been pricing in a rate cut or two from the central bank, betting that muted inflation combined with slower growth will force the Fed to ease policy and try to boost an ailing U.S. economy. But some economists had held off on making those calls, seeing more hope that the U.S. would reach trade deals and reduce the uncertainty that has hovered over economic projections.
Now that is starting to change, with economists warning that President Donald Trump's planned 5% tariff on all Mexican imports marks a significant escalation of trade tensions.
The announcement "adds yet another trade-related headwind to the growth outlook" and could force the Fed to cut rates, Michael Feroli, chief U.S. economist at JPMorgan Chase, wrote in a note to clients.
"Even if a deal is quickly reached with Mexico, which seems plausible, the damage to business confidence could be lasting, with consequences that might still require a Fed response," he wrote. "Accordingly, we now look for two 25[-basis-point] reductions in the federal funds rate target, in September and December."
The tariff announcement comes on top of deepening tensions between the U.S. and China on trade policy, a battle that was already weighing on investor sentiment and clouding the economic outlook.
"All said, the reignited trade tensions have skewed the risks to both U.S. and global growth further to the downside — a development which will no doubt receive close monitoring by central bank officials," Shernette McLeod, an economist at TD Economics, wrote in a research note.
The uncertain outlook was one major factor behind the Fed's pivot in January, when it backtracked from earlier signals that it would raise rates twice this year. The Fed instead shifted to a wait-and-see policy stance, with officials saying they would be "patient" in monitoring incoming data and deciding their next move.
But Michael Gapen, chief U.S. economist at Barclays, wrote in a research note that "trade tensions could escalate further before they de-escalate," souring investor sentiment and leading to tighter financial conditions.
"As a result, our outlook for U.S. economic and financial conditions has worsened, and we now expect the Fed to cut its policy rate by 75 [basis points] this year, beginning with a 50[-basis-point] cut in September," he wrote. "Earlier action is not out of the question, in our view, if financial conditions deteriorate rapidly."
Fed officials have sent few signals that they are leaning toward a rate cut at the moment.
Minneapolis Fed President Neel Kashkari, one of the central bank's most dovish voices, said in a May 31 interview with Bloomberg Television that he is "not quite there yet" on the need to ease policy given that the U.S. labor market remains strong.
Meanwhile, Fed Vice Chairman Richard Clarida said a day earlier that the Fed's patient stance remains appropriate since the economy is in a "good place." Still, Clarida said that the Fed would consider cutting rates if it saw a "material downside risk to our baseline outlook" or if inflation were to see a "persistent shortfall."
The Fed got some relatively good news on the inflation front on May 31, when the Bureau of Economic Analysis said the U.S. core personal consumption expenditure price index rose by 1.6% year over year in April. That marked an increase from the March figure of 1.5%, which was revised down from the previous reading of 1.6%.
While those figures show inflation remains below the Fed's 2% target, the upward trend provides some reassurance on Fed officials' views that the recent dip in inflation may be temporary, analysts said.
But the bleaker trade news likely negated any impacts that stronger inflation figures could have on dissuading investors away from their bets of Fed rate cuts, said Craig Elder, senior fixed-income research analyst at Baird.
"The Fed would love to stay on the sidelines through this year and next," he said. "But the pressure is increasing on them to take action."