22 July 2019
The Federal Reserve’s plan to shrink the balance sheet could be a move to rein in the bubbly stock market. Photo: Reuters
The Federal Reserve’s plan to shrink the balance sheet could be a move to rein in the bubbly stock market. Photo: Reuters

Is a deep correction looming over the US stock market?

The Federal Reserve first unveiled its plan to shrink the balance sheet in the Federal Open Market Committee minutes in May. Meanwhile, it raised interest rates by 25 basis points on Wednesday and unveiled more details on how it plans to reduce the size of the balance sheet.

With recent economic data in the US fairly mixed and inflation pressure showing signs of easing, why is the Fed in such a hurry?

The Citi US Economic Surprise Index has started to fall off its peak and is now close to the trough seen at the beginning of last year, which suggests recent economic figures have basically lagged behind market expectations.

And the growth rate in US commercial and industrial loans moderated to about 2 percent in May from double digits in previous months. The credit growth in commercial and industrial loans usually moderates or contracts before the US falls into a recession, as shown by historical data in the past 70 years.

That means broad US economic growth has already run out of steam despite encouraging job data.

Also, various inflation indicators have started to fall back.

Still, the Fed wants to go ahead with the balance sheet pruning. I believe there are four possible reasons.

First, real economic growth might be stronger than it appears. The Fed has more market and economic data on hand, and it should have a better picture about the economic growth prospect. It’s probably the Fed’s view that economic slowdown in recent months won’t last, and the overall uptrend will be sustained.

Second, the Fed is already behind the curve, and it has to accelerate its pace in raising rates. In fact, we discussed this point in March last year. The current unemployment rate and personal consumption expenditure suggest that the Fed target rate should be at 4.01 percent at the moment.

Third, the Fed might want to rein in soaring stock markets with tighter monetary policy. The US stock market has moved in tandem with the Fed’s policy since the 2008 financial crisis. The US market has kept setting new highs since the US election. The Fed may want to take a preemptive move to tame the bubbly market.

The last possibility is that the Fed is tightening now in order to create room for future easing if necessary.

Persistent tightening and weaker economic performances could combine to trigger a deep correction in the US stock market in the latter part of the second half.

If that happens, the Fed may ease its policy again and launch a new round of quantitative easing.

This article appeared in the Hong Kong Economic Journal on June 15

Translation by Julie Zhu

[Chinese version 中文版]

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Hong Kong Economic Journal chief economist and strategist

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