Why the Fed may sooner or later ease further

August 02, 2019 12:15
The Federal Reserve may stop shrinking its balance sheet soon to avoid any shocks to the financial markets. Photo: Reuters

The Federal Reserve has cut its benchmark interest rate by 25 basis points as most have expected. The market is closely watching the Fed's stance on future monetary policy.

Fed Chairman Jerome Powell cited signs of a global slowdown and simmering US trade tensions in explaining the US central bank’s move. Although he said the cut won’t herald a long series of rate reductions, he also said, “I didn’t say it’s just one rate cut.”

In my opinion, there are three potential reasons for the Fed to stop shrinking its balance sheet and even restart another round of quantitative easing (QE) soon.

First, the risk of a global recession is on the rise. The US-China trade war has lasted for more than one year, and there is no resolution in sight. That has already affected investor confidence and led to a rising risk of a recession. In fact, the PMI in several major economies has dropped below the 50 mark, which means the manufacturing sector is contracting.

Other indicators also show that companies are cutting capital investments. For example, Caterpillar, the world's leading manufacturer of construction and mining equipment, has reported negative sales growth in Europe, the Middle East and Asia.

The negative trend is set to ripple into the US sooner or later.

Second, although the Fed has slowed the pace of its balance sheet runoff since May, it has drained nearly US$600 billion of liquidity from the market since November 2014, according to its data.

Whenever there was a sharp decline in the balance sheet of the world’s four largest central banks, the financial market would see a bumpy ride, as we saw in 2012, 2014 and 2018.

The balance sheets of central banks in the US, Europe, Japan, and China are still shrinking. To avoid any shocks to the financial markets, the Fed may stop shrinking its balance sheet soon.

Third, a rate cut might be needed to put a cap on the US dollar, which has maintained a strong trend as it draws support from a relatively strong US economy.

Meanwhile, the European Central Bank is likely to launch monetary easing very soon, which means the dollar may strengthen further if the Fed holds back, and that is not what Powell and US President Donald Trump want to see.

I suspect the Fed is likely to relaunch another round of QE later this year at the earliest, or early next year.

This article appeared in the Hong Kong Economic Journal on Aug 1

Translation by Julie Zhu

[Chinese version 中文版]

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Hong Kong Economic Journal chief economist and strategist