As Fed Hikes and ECB Eases, Markets Could Get Wild

Over the next few weeks, the U.S. Federal Reserve and the European Central Bank are likely to put in place notably different policies. The Fed is set to raise interest rates for the first time in almost 10 years. Meanwhile, the ECB is expected to introduce additional unconventional measures to drive rates in the opposite direction, even if that means putting further downward pressure on some government bonds that are already trading at negative nominal yields.

In implementing these policies, both central banks are pursuing domestic objectives mandated by their governing legislation. The problem is that there may be few, if any, orderly mechanisms to manage the international repercussions of this growing divergence.

The Fed is responding to continued indications of robust job creation in the United States and other signs that the country’s economy is recovering, albeit moderately so. Also conscious of the risk to financial stability if interest rates remain at artificially low levels, the Fed is expected to increase them when its policy-setting Federal Open Market Committee meets on Dec.15-16.

The move marks a turning point in the Fed’s approach to the economy. In deciding to raise interest rates, it will be doing more than simply lifting its foot from the financial-stimulus accelerator; it will also be taking a notable step toward the multiyear normalization of its overall policy stance.

In the meantime, the ECB is facing a very different set of economic conditions, including generally sluggish growth, the risk of deflation, and worries about the impact of the terrorist attacks in Paris on business and consumer confidence. As a result, the bank’s decision-makers are giving serious consideration to pushing the discount rate further into negative territory and extending its large-scale asset-purchase program (otherwise known as quantitative easing).

In other words, the ECB is likely to expand and extend experimental measures that will press even harder on the financial-stimulus accelerator.

In a perfect world, policy makers would have assessed the potential for international spillovers from these divergent policies (including possible spillbacks on both sides of the Atlantic) and put in place a range of instruments to ensure a better alignment of domestic and global objectives. Unfortunately, political polarization and general policy dysfunction in both the U.S. and the European Union continue to inhibit such an effort.

As a result, lacking a more comprehensive policy response, the harmonization of their central banks’ divergent policies will be left to the markets — in particular, those for fixed-income assets and currencies.

Market Watch

Craig Erlam
Based in London, England, Craig Erlam joined OANDA in 2015 as a Market Analyst. With more than five years' experience as a financial market analyst and trader, he focuses on both fundamental and technical analysis while conducting macroeconomic commentary. He has been published by The Financial Times, Reuters, the BBC and The Telegraph, and he also appears regularly as a guest commentator on Bloomberg TV, CNBC, FOX Business and BNN. Craig holds a full membership to the Society of Technical Analysts and he is recognized as a Certified Financial Technician by the International Federation of Technical Analysts.