The meeting of the Federal Reserve’s rate-setting committee on Wednesday as well as the Bank of Japan’s on Friday could have major implications for foreign exchange markets. It should be pointed out of course that neither central bank is expected to act according to the majority of analysts. Regarding the Fed, it is clearer that no move is anticipated, whereas for the Bank of Japan, the odds of something happening are higher.
Turning attention to the Fed, the ‘will they / won’t they and when’ debate has been in full swing lately since the majority of economists now expect a move in December. However, the market is not sure there will even be a rate hike by the March 2016 meeting. Given this uncertainty, communication from the Fed will be crucial in deciphering the committee’s intentions. It has been frustratingly difficult to understand what the Fed is up to given the conflicting signals of different Governors and regional Presidents.
Overall if the Fed delivers a roughly similar message to the one in September, this will probably mean that the door for a December hike is gradually closing. If the situation is similar and the risks are similar, why go for a rate hike soon then, right? However, if the Fed takes note of the more positive atmosphere in financial markets after its decision to hold rates combined with some added confidence that the Chinese economy is not falling off a cliff, this could open the door towards a hike before the end of the year – provided no ugly surprises take place. Maybe such optimism would look like a U-turn by the cautious Fed and they will remain closer to their September story.
The latest shift of expectations towards more easing by the ECB could also complicate the Fed’s plans to tighten policy.
If the ECB is increasing its QE – as well as the Bank of Japan at some stage – while the Fed decides to embark on higher rates, the dollar could move sharply higher. Given the previous substantial rally by the dollar and its negative impact on inflation and US exports, the Fed may not want to risk further major gains by the dollar. Better to let currency traders buy the dollar because the ECB and BoJ are loosening policy, not because the Fed is additionally hiking rates. Therefore, the Fed’s resistance to raise could slow the dollar’s rally and would shield the US and vulnerable emerging market economies from dealing with a much higher dollar.
To sum up, although there are very good reasons for the Fed to hike interest rates, it may choose not to do so in 2015 so as not to accentuate the policy divergence between itself and other major central banks (ECB, BoJ, PBoC). The Fed’s statement on Wednesday following the meeting will probably provide clues as to the committee’s thinking and whether December is going to a ‘live’ meeting with respect to higher rates.