Why Trump's trade wars are pressuring both economy and Fed

A sharp pullback in U.S. hiring for May intensified fears that the economy has weakened and that many employers have grown nervous, in part from President Donald Trump's escalating trade wars.

Yet the stock market soared and bond yields fell because investors found a reason to cheer: The tepid employment report magnified their expectations that the Federal Reserve will cut interest rates in the coming months, perhaps beginning in July, to support the economy.

Trump, who has railed against the Fed for not cutting rates this year, may get his wish, if only because his trade conflicts with China, Mexico and other key nations are posing an economic threat.

It isn't at all clear how effective Fed rate cuts would be when mortgage rates and other borrowing costs in the United States are already historically low. What's more, rate cuts carry their own risks. With the Fed's own key short-term rate already low, further reductions could weaken the central bank's ability to fight a future recession. Lower Fed rates might also contribute to dangerous bubbles in stocks or other assets.

On top of that, the Fed's policymakers face an unusually uncertain environment. Though the White House's threats to impose tariffs on all Mexican and Chinese imports are pressuring the economy, a resolution to those conflicts could quickly end the damage they might be causing. In that case, the Fed might have cut rates prematurely.

A rate cut "is a bit of insurance in case the economy deteriorates more quickly," said Joe Brusuelas, chief economist at RSM, a tax consulting firm.

Employers added just 75,000 jobs in May, the Labor Department said Friday , only about a third of April's pace. The unemployment rate held at a five-decade low of 3.6%. So far this year, employers are adding 164,000 jobs a month, enough to keep lowering the jobless rate over time, but down from last year's pace.

Economic growth is projected to slow, with most analysts forecasting just 1.5% growth at an annual rate in the April-June quarter, after a healthy 3.1% in the first three months of the year.

Some economists worry that growth is already slowing even before the full effects of the trade fights have kicked in. For most of the spring, investors thought that a deal would be reached with China, after Trump had imposed tariffs last year.

Early last month, Trump turned more combative: He suddenly raised the import taxes on $200 billion of Chinese goods to 25% from 10%. The president argued that the increase was necessary because China had backed away from parts of an emerging deal.

And last Friday, Trump said he would impose 5% tariffs on all imports from Mexico, and would ratchet those duties another 5% each month until they hit 25% in October, unless Mexico stopped the flow of migrants through its country from Central America.

The U.S. imported nearly $350 billion in goods from Mexico last year, including autos and auto parts, electrical components, and produce such as tomatoes, avocadoes, and cucumbers. If those duties were to reach 25%, they would restrain U.S. economic growth and raise prices for businesses and consumers.

"It's a bad sign that we're already getting a slowdown, because there's less margin for error, less room to absorb shocks" from the trade war, said Josh Wright, chief economist at recruiting software firm iCIMS and a former Federal Reserve researcher.

Trump tweeted Friday afternoon that there is a "good chance" that his administration and Mexico will reach an agreement to stave off the tariffs.

All of which adds another level of complexity for Fed Chairman Jerome Powell. It isn't clear how long the taxes on Mexican goods, if imposed, would remain in place. And Trump is scheduled to meet China's President Xi Jingping at the end of the month at a global summit in Japan. Washington and Beijing could make progress toward a deal. Or, if talks fail, Trump could proceed with his threat to impose tariffs on the remaining $300 billion of Chinese imports that haven't yet been taxed.

There are some signs the trade fights are already souring the economy. Companies are reining in their orders for industrial machinery and other manufactured goods. Exports have also slowed, in part because of retaliatory tariffs imposed by China and Mexico and because of sluggish growth in Europe and Asia.

Manufacturers have added just 5,000 jobs in the past three months — much weaker than last year's monthly average of 21,000. U.S. factory output has fallen in three of the past four months.

"That's the trade war coming home to roost," Brusuelas said.

Brusuelas argues that the trade wars have placed an "uncertainty tax" on the economy, which has discouraged employers from hiring or investing in new equipment. A Fed rate cut, by boosting financial markets, might shore up business and consumer confidence and prompt some additional spending by wealthier households that would benefit from higher stock prices.

"The Fed can't solve this problem," he said. "But it can mitigate the uncertainty tax that the trade fight has put on the economy."

The Fed could wait until September to cut rates to get a better read of how the trade fights play out. Yet doing so could cause the financial markets to react impatiently and fall further, worsening business and consumer confidence.

"The Fed is in an awkward position because of how quickly external events are moving," Wright said. "It will be very hard to stick this landing."