The looming Fed’s loose monetary policy

Wei Hongxu

The US administration’s new tariff threats against Mexico and India show that the US has a tendency to expand its range of trade frictions with other countries. This has undoubtedly created further impact on the global capital market.

The US administration’s new tariff threats against Mexico and India show that the US has a tendency to expand its range of trade frictions with other countries. This has undoubtedly created further impact on the global capital market. Investors are increasingly intimidated by the possible recession in the US economy, and many institutions are constantly coming up with new opinions about the Federal Reserve’s “wait-and-see” monetary policy. Anbound recently pointed out that the Fed’s monetary policy tends to match Trump’s policy. Under Trump’s pressure on the Fed to cut interest rates, and factors such as the slow US economic growth, tightening of financial conditions and weak core inflation, the Fed could lose its “patience” on interest rates, leading to a possibility of loose monetary policy call.

For the latest Cambodian Business news, visit Khmer Times Business

The Fed kept interest rates unchanged at the beginning recently and has hinted that it has no intention of changing the monetary policy in the short term. However, the new bond-buying program shows that the Fed intends to lower the short-and medium-term funding rate, thereby achieving a disguised rate cut.

On May 30, the New York Fed announced its preliminary plans for the bond-buying program after the end of its balance sheet reduction. It is indicated that from October 2019, the Fed will reinvest the maturity principal of federal institutional bonds and institutional mortgage-backed securities (MBS) into US treasury bonds through the secondary market. The data shows that as of May 22, the Fed held a total of $1.56 trillion in institutional MBS, $2.3 billion in federal institutional bonds, and $2.11 trillion in US Treasury bonds. CITIC Securities pointed out that after the Fed’s balance sheet reduction ends in this year, the Fed reinvestment of the monthly maturing principal of MBS in short-and medium-term US Treasury bonds will lower the short-term yield of US Treasury bonds and thereby change the inverted yield-curve of US Treasury bond, which is a measure that is similar to an interest rate cut. These changes in the Fed’s assets structure could also signal that the Fed has an intention to cut interest rate.

Intriguingly, the Fed is still hastening its balance sheet reduction before its end. The latest balance sheet figures, released on May 2, showed that the Fed reduced its assets by $46 billion in April, bringing the total down to $3.89 trillion, the lowest since November 2013. The Fed’s balance sheet peaked at $4.5 trillion in 2014, shedding $580 billion in assets since it began a gradual downsizing activity in October 2017, a record in the Fed’s history. This also signifies that the Fed’s monetary policy is approaching a tipping point. That means a sudden reversal of monetary policy is more likely to occur when the Fed’s balance sheet reduction ends.

Increasing data are indicating that the trend of a US economy slowdown is forming. This trend will become more pronounced during the second quarter of the year. The weak inflation statistics released by the US Department of Commerce on May 30 could also bring pressures to the Federal Reserve to cut the interest rates. The data showed that the personal consumption expenditure (PCE) price index, excluding volatile food and energy components, rose one percent last quarter, its smallest increase in four years. This year’s inflation rate has remained below the target of two percent, due to the sharp slowdown in domestic demand.

Does this mean that the Fed’s moderate price pressures are really caused by temporary factors? The latest data released by the the government also shows the first quarter gross domestic product grew by 3.1 percent year-on-year, down from the estimated 3.2 percent. The Federal Reserve Bank of Atlanta expects the US GDP growth to slow to 1.3 percent in the second quarter. The economic slowdown also largely reflects the stimulating effect of the Trump administration’s substantial tax cuts and increased spending last year. Other than that, the trade dispute between the US and China has also affected the economy.

Anbound’s researchers believe that the gradual loss of independence, in addition to the Fed’s “Trumpisation” in its monetary policy, one that caters to the market to suit the government’s needs, has made an interest rate cut and a push for QE become increasingly possible. In view of the worsening economic outlook in the US, more financial institutions are also predicticting that the Fed will cut interest rates this year.

According to the Financial Times, with the intensification of trade tensions and growing concerns about the global economic situation, the Fed’s interest rate cuts this year are almost certain to take place. Federal Reserve vice chairman Richard Clarida also said that if the risk is appearing to increase, the Fed will be prepared to relax its policy. JPMorgan Chase expects the Fed to cut interest rates twice this year; if the US raises tariffs on Mexican imports to 25 percent, the Fed’s interest rate cuts need to greatly exceed 50 basis points. Barclays also expects that the Fed will cut interest rates by 75 basis points during the year and may cut interest rates by 50 basis points in September. FedWatch tool of the Chicago Mercantile Exchange says that the current probability of rate cut in September is 68 percent, and the probability of a further interest rate cut in December is 58 percent.

Once the Fed adopts a loose policy again, it will also push central banks around the world towards forming a more relaxed monetary environment. This will be a new development in the global economy. The scenario of excess capital will therefore be further aggravated. If monetary easing does not cause inflationary pressures, especially in the case of global overproduction, then it will push and maintain asset prices at high levels. For major capital markets, higher asset prices may be good news, but if the trade situation continues to deteriorate, then the flow of financial capital will be further increased, and the possibility of turbulence occurring in individual markets cannot be ruled out. Under such circumstances, maintaining the stability of the capital market and maintaining the confidence of investors should be the primary task of every country in order to avoid a financial warfare from breaking out.

As for China, Anbound has proposed that China’s macroeconomic policies should be well-prepared to prevent the impacts of international capital flows from affecting China’s capital market and the yuan exchange rate. Regarding the changes in the Fed’s monetary policy, China will also need to adopt a loose monetary policy to maintain the stability of the capital market, while at the same time promoting the flow of funds to the real economy, thereby adding vitality to the market and enhancing market confidence.

In conclusion, the slowing US economy and changes in international trade environment will drive the Fed to adopt a loose monetary policy. In this regard, China should be prepared to respond with a corresponding monetary policy.

Wei Hongxu, graduated from the School of Mathematics of Peking University with a Ph.D. in Economics from the University of Birmingham, UK in 2010 and is a researcher at Anbound Consulting, an independent think tank with headquarters in Beijing

Related articles