By Howard Schneider
WASHINGTON (Reuters) - A drop in the consumer outlook for inflation and intensifying trade tensions drew caution from Federal Reserve officials on Monday as policymakers faced fresh market volatility and a renewed set of risks.
U.S. equity markets continued a sell-off that began last week when President Donald Trump imposed new tariffs on Chinese imports and deepened when China announced plans to retaliate. Major U.S. stock indexes were down from 2 to 3 percent on Monday, and bond investors sharply increased their bets that the Fed would be forced to cut rates this year.
Fed officials have largely discounted the trade war in their economic and policy outlooks, arguing that the likely impact on growth in U.S. gross domestic product would be small unless the trade tensions persist and intensify.
After the collapse of U.S.-China talks last week and the threat of tariffs ratcheting ever higher, there was more reason to believe that might happen.
"If it's the worst-case scenario and it's ever-increasing tariffs for an extended period of time, that could change things, that could have a real effect on U.S. GDP growth," Minneapolis Federal Reserve bank President Neel Kashkari said on CNBC.
In an interview on Boston's WBUR radio, Boston Fed President Eric Rosengren said that while the United States is "strong enough" to weather the trade storm, "if it starts to be a situation where we expect tariffs to be high for a long period of time, it does start to disrupt trade patterns."
Traders and analysts on Monday said the volatility is likely to continue regardless.
"You cannot game what two leaders...are going to do from day to day," said Anthony Saglimbene, global market strategist with Ameriprise Financial Services in Troy, Michigan, of the high-stakes standoff between Trump and Chinese President Xi Jinping.
RATE CUTS BACK ON RADAR
Fed officials have been careful so far to say that nothing yet has changed their main outlook. That calls for rates to be held in their current range of between 2.25 and 2.5 percent until either growth demonstrably weakens and inflation falls further, warranting a rate cut, or faster inflation makes higher rates warranted.
Traders in the federal funds futures market, however, have moved decisively in favour of a rate cut over the past few days as the tariff war escalated. Data from the CME Group now see the Fed cutting rates in October, with a near 10 percentage point shift since Friday in the probability of a rate reduction at that Fed meeting.
The pressure on the Fed could come from several directions - from economic growth that is likely to slow if the tariff wars continue and global trade declines, to the "wealth effects" that could directly impact business and household confidence and spending if the stock declines continue.
A further complication: The inflation outlook among U.S. consumers dipped sharply in April, countering Fed policymaker hopes that inflation dynamics will improve and the pace of price increases soon rise towards their target level.
Survey data released by the New York Federal Reserve on Monday showed consumer expectations of the inflation rate over the next year fell to 2.6% from 2.82% in the March survey. The nearly quarter point drop was the third-largest since the survey was launched in mid-2013. The outlook for inflation over the next three years also fell, to 2.69% from 2.86%, evidence that medium-term expectations have also weakened in recent weeks.
Following the Fed's most recent meeting, Chairman Jerome Powell and others said they felt recent weak inflation readings were driven by "transitory" factors that would disappear over time and allow overall inflation to rise.
But a drop in inflation expectations is another matter, and could be evidence that households and businesses are losing faith in the Fed's ability to deliver on its inflation goal - a worrying development for central bankers who feel their ability to keep expectations set around their inflation target is critical to meeting the goal.
As of the Fed's last policy statement on May 1, officials said they felt expectations remained stable.
While consumer surveys are discounted by some officials as overly influenced by things like changes in gasoline prices and other costs that consumers closely monitor, some broader market expectation measures have also shifted. Since late April, for example, a St. Louis Federal Reserve measure of the inflation rate expected five years from now, based on trading in different types of bonds, dipped to 1.9% from 2.1%, a sign traders also see weaker inflation ahead.
(Reporting by Howard Schneider; Additional reporting by Herb Lash and Trevor Hunnicutt; Editing by Andrea Ricci)