Global markets rise before Fed announcement

With US Federal Reserve due to announce rate decision on Wednesday, global markets rally at expectation of end of months of uncertainty

Photo by: Reuters
Photo by: Reuters

No sooner will the Federal Reserve raise US interest rates than it must make more decisions on how to drain markets awash in cash and, further down the road, how to shrink its swollen balance sheet.

The US central bank is widely expected on Wednesday to hike its key federal funds rate by a modest 0.25 percent. It would be the first tightening in more than nine years and a big step on the tricky path of returning monetary policy to a more normal footing after aggressive bond-buying and near-zero borrowing costs.

The New York Fed, which handles the mechanics of monetary policy three blocks from Wall Street, will turn on Thursday to a suite of lightly tested tools to pry rates higher.

It will be far more difficult than in the past.

Years of unprecedented stimulus has left the Fed swollen with $4.5 trillion in bonds, and the banks bursting with $2.6 trillion in reserves. All this liquidity has eclipsed the effectiveness of the fed funds market as the central bank's primary policy lever.

So the Fed will seek to raise rates to the new range of 0.25 to 0.5 percent by setting a floor and a ceiling with other levers that may need to be adjusted on the fly, depending on the reaction of markets.

A December 9 Reuters poll showed the likelihood of a hike on Wednesday was 90 percent with economists forecasting the federal funds rate to be 1.0-1.25 percent by end-2016 and 2.25 percent by end-2017.

Questions remain on how aggressively the Fed will rely on these tools and, later, when and how much it will shrink its portfolio.

Likely after a few rate hikes are out of the way next year, the Fed will have to decide how to drain its portfolio of Treasury and mortgage bonds, either by allowing them to run off naturally or by selling outright. For now it is topping up the balance sheet as assets mature.

Some policymakers and outside experts are also saying the Fed could choose to keep the portfolio big in order to stabilise financial markets and to provide an additional policy tool to target sectors of the economy or bond market.

Former Fed Chairman Ben Bernanke said last month that leaving the balance sheet as is "wouldn't be a problem."

The rate hike will separate the Fed from major central banks in Tokyo, Frankfurt, Beijing and elsewhere that are all battling to stimulate their economies and generate growth. There were signs that the underlying strength of the US consumer-led economy would continue even after a rate rise.

Markets set a positive stage for the Fed's potentially historic turn as US stock futures rose ahead of the market open on Wednesday and bond markets and the dollar were steady. Analysts said that after weeks of preparation a surprise decision not to hike would be the more disruptive choice.