December 11, 2019 / 4:12 PM / 3 months ago

Explainer: What the U.S. Federal Reserve will be watching in 2020

WASHINGTON (Reuters) - The U.S. Federal Reserve is expected to keep interest rates unchanged when it wraps up its final policy meeting of the year on Wednesday.

FILE PHOTO: The Federal Reserve building is pictured in Washington, DC, U.S., August 22, 2018. REUTERS/Chris Wattie/File Photo

The U.S. central bank is currently in a holding pattern after cutting interest rates three times this year to boost the economy in the face of threats posed by slowing global growth and the U.S.-China trade war. But Fed officials have indicated they still see more chance of the economy softening than strengthening.

Here’s what the Fed will be keeping an eye on in 2020:

IF JOB GROWTH INDICATORS BECOME WORRISOME

The U.S. economy has added more than 20 million jobs since emerging from recession in 2009, and the unemployment rate is currently near a 50-year low at 3.5%. The pace of job growth has been slowing, which is consistent with an economy in which untapped labor is becoming scarce. Fed officials expect that to happen. What would worry them is if not enough jobs are being created to keep up with U.S. population growth. Economists and Fed officials estimate that figure to be somewhere between 75,000 and 125,000 jobs a month on average. Another one to watch? A newer, more real-time economic indicator known as the “Sahm Rule” which posits that when the 3-month average jobless rate rises half a percentage point above the low of the previous 12 months, the economy is in recession, or near one.

(GRAPHIC: Fed will be watching job growth in 2020 - here.jpg)

IF U.S. ECONOMIC GROWTH SLOWS BELOW 2%

The economy grew 2.9% last year, but forecasts for this year are around 2.5% growth due to the fading impact of the Trump administration’s tax-cut package and slowing global growth. The U.S. economy is currently growing around its potential, which economists put at between 1.7% and 2.0%. Fed officials have already said if it weakens beyond the trend pace, that could prompt another interest rate cut. Consumer spending, which accounts for roughly 70% of U.S. economic activity, has held up well so far. If it shows signs of deteriorating, the Fed will pay attention.

(GRAPHIC: Fed will be watching the yield curve in 2020 - here.jpg)

IF INFLATION HEADS THE WRONG WAY

The Fed has targeted a 2% inflation rate since 2012, but it consistently undershot that goal as the U.S. economy continued to recover from the last recession. For much of 2018, inflation was actually in the sweet spot of around 2%, only for it to drop back below that level this year. This matters to the Fed because the more that lower inflation expectations become engrained in people’s minds, the more risk there is that price rises slow further. And while slower-rising prices might sound like a good thing, once inflation hits zero or below, as it has in Japan and Europe, it begins to slow spending and growth, as consumers put off purchases in the expectation prices might fall further. So if inflation moves further away from the 2% target on a sustained basis, the Fed could see a need to cut interest rates again in order to try and boost it.

(GRAPHIC: Fed will be watching GDP in 2020 - here.jpg)

IF THE U.S.-CHINA TRADE WAR INTENSIFIES

The Fed has been buffeted for much of 2019 by the economic uncertainty caused by the Trump administration’s chaotic trade policy, in particular the U.S.-China trade war. The spillover from escalating tit-for-tat tariffs between the world’s two largest economies has caused a drop in U.S. business investment, and put U.S. manufacturing in recession. A deal to resolve the tensions has yet to materialize despite months of negotiations, and if U.S. President Donald Trump goes ahead with Dec. 15 tariffs on some $156 billion of Chinese exports to the United States, including cellphones, laptop computers, toys and clothing, that would be bad news for the crucial holiday shopping season. Even if a deal is reached, Trump’s propensity to swiftly change his mind, particularly against the backdrop of a bid for re-election next year, will keep the Fed guessing.

(GRAPHIC: Fed will be watching inflation in 2020 - here.jpg)

IF THE YIELD CURVE INVERTS OR FUNDING STRESS EMERGES AGAIN

One financial market indicator that several Fed officials fret about is the shape of the so-called “yield curve.” When it inverts - effectively when short-term securities pay a higher rate of interest than longer-term ones - it suggests that investors expect a recession. In March, the spread between 3-month Treasury bills and 10-year notes inverted for the first time since 2007, which gave succor to the Fed’s decision to begin cutting interest rates in July. It has since returned to a normal upward slope. Should it invert again, jitters may return.

(GRAPHIC: Fed will be watching business investment in 2020 - here.jpg)

A SURPRISE?

As in real life, the Fed has to deal with unexpected events. Oil shocks in the 1970s hit the United States after an embargo by Arab exporters and the Iranian revolution, forcing the Fed to raise rates to tame a surge in inflation. Another oil shock today would have less impact, as the United States has diversified its energy base. The Fed was also caught off guard by the severity of the last U.S. recession and the 2008 global financial crisis, which made the central bank cut interest rates to near zero and launch several controversial bond-buying programs to keep the economy afloat. Other crises that forced the Fed to respond included the Sept. 11, 2001, attacks on the United States and the Black Friday market collapse in the 1980s. In 2015, the Fed raised rates less than it planned as financial markets dropped on concerns over slowing Chinese economic growth. Simply put, with the global economy so interconnected, what happens elsewhere - from Britain’s protracted attempts to leave the European Union to democracy protests in Hong Kong - is on the Fed’s radar.

Reporting by Lindsay Dunsmuir; Additional reporting by Ann Saphir; Editing by Paul Simao

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