Explainer: What the U.S. Federal Reserve is watching this year

By Lindsay Dunsmuir

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

The U.S. central bank is currently in a holding pattern after cutting interest rates three times last 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 is keeping an eye on as 2020 progresses:

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 labour 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.

IF U.S. ECONOMIC GROWTH SLOWS BELOW 2%

The economy grew 2.9% in 2018, but Fed officials forecast economic growth to be around 2.2% last year 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.

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.

IF THE U.S.-CHINA TRADE WAR RE-ESCALATES

The Fed was 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. Neither has yet to recover, with manufacturing also hit by Boeing's <BA.N> suspension of production of its troubled 737 MAX jetliner.

Some trade tensions have eased with the signing earlier this month of a "Phase 1" trade deal between Washington and Beijing, but U.S. President Donald Trump has simultaneously threatened Europe with more tariffs. Even if the U.S.-China trade truce holds, Trump's propensity to swiftly change his mind, particularly against the backdrop of a bid for re-election this year, will keep the Fed guessing.

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 succour to the Fed's decision to begin cutting interest rates in July. It inverted briefly again on Tuesday for the first time since October as investors worried about the economic impact from a coronavirus outbreak in China. If it happens on a more prolonged basis, jitters could return.

A SURPRISE?

As in real life, the Fed has to deal with unexpected events. And with the global economy so interconnected, what happens elsewhere is on the Fed's radar. From oil shocks in the 1970s and the Black Friday market collapse in the 1980s, to the Sept. 11, 2001, attacks, all have changed the course of interest rates. More recently, in 2015, the Fed raised rates less than it planned as financial markets dropped on concerns over slowing Chinese economic growth. So far this year, global financial markets have been temporarily rattled by the U.S. decision to kill a top Iranian military commander in a targeted air strike, which increased tensions between the two adversaries and sparked concerns of escalating unrest in the Middle East.

But the biggest surprise so far has been China's coronavirus outbreak. On Monday, major stock indexes experienced their worst selloff in about four months on worries about the outbreak's impact on Chinese and global growth as the death toll rose. As a result, investors have brought forward estimates of a Fed rate move, with now roughly even odds the U.S. central bank will cut interest rates again by the end of July.

(Reporting by Lindsay Dunsmuir; Editing by Paul Simao)