After the publication of data on the level of employment by the Labor Department of the United States, a few weeks ago, the Fed announced the possibility of increasing interest rates before the end of the year. This news was taken by the markets and in general by the economic system, as a sign that the US economy is finally restored. The cost of capital can then go back to hit normal levels, helping to contain inflation.

During the last seven years, the Fed has always held interest rates close to zero, mainly because the role of this institution has always been maximizing the employment rate, and provide impetus to US economy. Finding themselves having to deal with the biggest recession since World War II, with an estimated loss of 765,000 jobs, it can be said that the approach taken by the US central bank was almost obligatory.

Bringing interest rates to a minimum level, the Fed has effectively driven the US economy out of the economic crisis. This makes sense if we think that interest rates are set by central banks through the purchase and sale of treasury bills in the short term, mostly traded with commercial banks. The Fed has been using this, as well as other methods, to support the economy in recent years, in particular buying mortgage securities and other bonds to help bring down long-term rates further. This strategy, known as quantitative easing, has encouraged loans and mortgages creating a boom in the financial market and contributing to sustained economic expansion.

The data about employment levels released in November by the Labor Department clearly shows that the unemployment rate reached 5%, which many economists consider to be a level of full employment. Confidence in the increasing of the employment rate has replaced the general fear of a possible collapse of the economy due to the slowdown in Asian developing countries. Indeed, issues such as the slowdown of the Chinese economy, the devaluation of the Renminbi, the overproduction of crude and the consequent collapse of its price, as well as the fall in world stock markets last summer, were the themes that strongly influenced Fed’s decision.

But data seems very clear and no longer attackable: household spending and investment rose at a rapid pace in recent months, and the real estate is further enhanced; however, net exports have stalled. The indicators of the labor market show that the underutilization of the labor force has declined since early this year.

As always, history teaches us, and it seems legit to consider in the overview also some previous US experiences about interest rates decisions that have generated a slower and uncertain economic relief, often making it tremendously difficult for workers to be able to demand and obtain higher wages. But stock markets seem to be sure about the next steps: the Fed will raise interest rates later this year, and in fact the impact has already being recorded in the Brent market, which is strongly linked to the prices of exchange rates.

The fall in the price of Brent below $45 per barrel in recent weeks is a clear example. The fact that the market is absorbing this possible change is indicating that at the date of the event the impact on the stock market will be much less drastic. But there is another important event that is affecting market decisions, which almost obscures the decision of the Fed: the meeting of the board of the European Central Bank, scheduled for December the 3rd, 2015. During this meeting, the ECB is expected to increase the firepower of its monetary policy, extending the quantitative easing undertaken earlier this year.

In short: in December, the streets of the two central banks, European and American should diverge, making more expansive the first and more restrictive the second. This expectation is weakening the euro, which is now around 1.06 on the dollar.

Recent weeks trend makes perceivable that the markets are awaiting the decision of Draghi for two reasons:

  1. It chronologically comes first
  2. It might influence Fed’s decision

The ECB in fact could do four things:

  • Lower the rate of bank deposits in ECB (currently -20%)
  • Increase the amount of the quantitative easing
  • Leave the amount of quantitative easing unchanged but increase its durability.
  • Mix the three actions mentioned above

If the ECB will do more than the market expects, it is very likely to see the euro depreciating further, which could lead the Fed to postpone again the decision on rates.

This seems to be the first time that the Fed will have to adapt to the decision of another central bank and not vice versa.

Maria Mura | Energy Consultant

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