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Draghi and Yellen brace for December policy decisions

Saturday, October 24, 2015 - 11:25
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Janet Yellen, chair of the U.S. Federal Reserve (left) speaks with Mario Draghi, president of the European Central Bank, during the Jackson Hole economic symposium, sponsored by the Kansas City Federal Reserve Bank, at the Jackson Lake Lodge in Moran, Wyoming, US on Friday, Aug 22, 2014.

Janet Yellen and Mario Draghi will end the year shaping each other's decision making.

That's what some economists are saying a day after European Central Bank President Draghi all-but committed to fresh stimulus for the euro-area in December. The same month was already a focal point for investors debating whether Federal Reserve Chair Yellen would raise the US benchmark for the first time since 2006.

The upshot is that the final month of the year, traditionally a time for winding down and vacations, will be the scene for two of the biggest policy decisions of 2015, with repercussions for currencies, stocks and bonds around the world. The outcome will either be the long-anticipated split in transatlantic policy or a united extension of easy money.

How the euro trades against the dollar in the coming weeks is a key factor for investors trying to gauge the outcome. Europe's shared currency tumbled to a two-month low on Thursday after Draghi's stimulus signal.

"There's this game of currency tennis between the Fed and the ECB and it will continue play out for while longer," said Nick Kounis, head of macro research at ABN Amro Bank NV in Amsterdam.

As Mr Kounis sees it, the Fed's decision to delay increasing rates in September pushed the dollar down against the euro, threatening European inflation by making the bloc's exports more expensive and its imports cheaper. That forced Mr Draghi to say he's considering even looser monetary policy when ECB officials next convene on Dec 3.

If Mr Draghi acts, weakening the euro, then the likelihood of a stronger dollar would probably influence the Fed's thinking when its policy makers gather two weeks later, said Mr Kounis.

"The signal from the ECB makes a December Fed rate hike less likely by pushing the dollar back up against the euro and tightening US financial conditions," said Krishna Guha, vice president at Evercore ISI in Washington.

By contrast, if global equity markets continue their rally on the back of ECB action then that could "give the Fed a bit of a smokescreen to launch its first rate hike," said Steve Barrow, head of Group-of-10 strategy at Standard Bank Group Ltd. in London.

That would mark a new era, with two of the world's largest central banks pulling in opposite directions.

"We know that monetary trends between the US and eurozone have been diverging for a while, but polar-opposite moves in the same month would surely take divergence to a new level - and perhaps euro/dollar to a new low," Barrow said.

Ms Yellen last month cited "financial developments" when the Fed chose not to tighten for the first time since 2006. Vice chair Stanley Fischer and New York Fed president William Dudley have since said an increase this year is still likely provided events overseas don't undermine forecasts for higher inflation.

What the ECB does may not be crucial for the Fed given that a gain in stocks would offset a strengthening of the dollar, according to Neil Dutta, head of US economics at Renaissance Macro Research LLC in New York.

The "ECB meeting plays a very little role in how we think about US monetary policy or the US economic outlook," he said.

The Fed could indeed still have dominance over global monetary policy. If US officials start indicating they will delay rate hikes until 2016 then the euro could reverse its fall against the dollar, forcing the ECB to be even more aggressive by taking the rate on overnight bank deposits more negative, said Dirk Schumacher, an economist at Goldman Sachs Group Inc.

"If Fed 'lift-off' in December continues to be priced out, Mr. Draghi's hand would be forced, making a deposit-facility- rate cut our base case in order to cap euro strength," said Mr Schumacher.

BLOOMBERG