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All Eyes on the Fed
The Board of Governors of the US Federal Reserve is scheduled to meet this coming Tuesday and Wednesday in what will be a key event for financial market participants around the world during this back-to-school period. Why do the Fed's decisions matter so much to the global economy right now? With the euro zone and Japan growing less robustly than the United States, the European Central Bank and the Bank of Japan (which also meets on 20 and 21 September) look set to hold policy rates low for some time, meaning that the Fed's decisions will largely determine the spread between US interest rates and those of the world's other main economies. This spread is a major determinant of exchange rates, in particular the rate of the euro against the dollar.
What can we expect? Everything hinges on the job market. Nonfarm payrolls, especially, are closely watched by market participants. Despite losing a little ground in August, these numbers have been strong of late, with an average 232,000 net jobs created in the last three months, which is high in historical comparison. The unemployment rate, meanwhile, is sitting at 4.9%. The post-crisis reduction in unemployment can be partly attributed to a lower participation rate, i.e. the portion of the population in employment or looking for work. However participation has begun increasing recently without leading to an increase in the unemployment rate, which is an encouraging sign. Annual wage inflation stands at around 2.5%. In short, the US economy is running at close to what economists would call full employment.
Taken in isolation, this situation would call for an increase in policy rates. Nevertheless the Fed is in a delicate position. On the one hand, the domestic recovery is weak relative to what would be expected in a normal cycle, and the Fed could stifle the economy's tentative growth by raising rates too quickly. It also has to weigh the impact of its decisions on the rest of the world, particularly on a number of emerging markets where many companies are heavily indebted in US dollars. A slowdown in the global economy would affect the USA through weaker external demand. On the other hand, the Fed has to be ready to cope with future negative shocks. By increasing rates now, it would give itself a safety buffer.
Comments by some of the Fed governors just ahead of the quiet period which began on 13 September sparked significant market volatility. The market thinks a rate hike in September is relatively unlikely. Is it being complacent? We will find out on Wednesday at Ms Yellen's press conference.
BGL BNP Paribas
Published in the Lëtzebuerger Journal on 19 September 2016.