US interest rate rise: “Currencies critical in wake of the Fed”

17th December 2015

Stephanie Flanders, chief market strategist for Europe at JP Morgan Asset Managementset out her view on the US Federal Reserve’s move to raise interest rates for the first time since 2006

It was expected to be a “dovish” rate rise and so it proved. Initially, at least, investors are choosing to focus on the slow pace of monetary tightening that Federal Reserve chair Janet Yellen has emphasised, not the vexed question of whether yesterday’s move should have happened at all.

Dovish or not, Yellen and her colleagues at the Federal Reserve will be hoping that this historic first rate rise will mark the beginning of several – even if they take longer to arrive than usual. The world cannot afford to have the Fed join the long list of developed country central banks that have raised interest rates since the global financial crisis, then later been forced into reverse

Many factors will determine the pace and direction of US monetary policy from here, notably the strength of US consumption and investment, and whether we see another wave of downward pressure on world goods prices from the adjustments under way in China and emerging markets.

Arguably, the best single indicator of how this process is going will be what happens to the dollar.

The US currency usually strengthens in the lead-up to higher interest rates. But once the tightening cycle has got under way, the greenback has tended to turn. The consensus this time is that the dollar could have further to go, particularly if expectations for future interest rates start to move up closer to the forecasts of Fed policy makers themselves. Some further dollar strength would be manageable. But another leap upwards could be very damaging, not just for the balance of the US recovery but for broader global economic stability. It would ratchet up the pressure on emerging market economies. It could also hit investor confidence, for example by raising renewed concerns about US corporate profits.

Foreign exchange moves are notoriously hard to predict. They do not reliably follow economic fundamentals – for example, the fact that the eurozone’s current account surplus is high and rising, while the US current account deficit is on the way up. Nor do they always follow the cues of central banks.

We could see another bout of global currency instability due to concerns about China or global growth. That’s not something that the Fed – or the ECB – can reasonably control. But policy has played a big part in determining the value of the euro in the past couple of years, and it could also make a difference in 2016.

The ECB’s efforts to loosen monetary policy earlier this month went down much worse with the financial markets than this long-awaited tightening by the Fed. But with those policy moves the ECB showed it was willing to expand the central bank’s programme of quantitative easing – sovereign bond purchases – by at least a third. It also took the key ECB policy rate further into negative territory. The only thing that the ECB did not achieve – or aim for – this time was a further push-down in the value of the euro.

Of course, that was tactical. ECB president Mario Draghi did not want to make it more difficult for the Fed to raise interest rates this week. But it would be good news for the world, and for investors, if that reduced desire to push the euro down further were also a sign of things to come.

The ECB is a long way from following the Fed on the path to higher rates. But we should all hope it has less reason to talk down the euro next year than it did in 2014 and 2015. For all the talk of the cheap euro boosting exports, domestic demand has been the key bright spot in Europe’s recovery this year. The more that European policy makers can do to support that home-grown growth, the easier it will be for struggling emerging market economies in 2016 and the easier things will be for the Fed.

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