Fed could set off year-end fireworks

An eagle tops the U.S. Federal Reserve building's facade in Washington, July 31, 2013. REUTERS/Jonathan Ernst

By Jonathan Spicer

NEW YORK (Reuters) - The possibility that the Federal Reserve could finally start to trim its extraordinary stimulus for the economy could make this week an explosive one for financial markets.

Though the odds still point to no major policy change when U.S. central bankers meet December 17-18, most of the recent domestic economic data suggest the beginning of the end of their massive bond-buying program is coming sooner than later.

If it acts it may reflect as much a growth in confidence in the global economy, for whom the withdrawal of the flow of cheap dollars will be a shock, as in the recovery in the United States alone.

Growth in jobs, retail sales, services and overall output in the world's biggest economy - combined with last week's breakthrough budget deal in Washington - has convinced some economists that the Fed will announce a reduction to its $85-billion a month in purchases on Wednesday.

While that could amount to a vote of confidence in the halting recovery from the Great Recession, the risk is that Fed Chairman Ben Bernanke's message sets off a market selloff that undermines growth worldwide.

The question is whether more U.S. fiscal stability and some good signs out of Europe and Asia will convince key Fed policymakers that the U.S. economy can handle less monetary support, and that investors won't overreact.

"Tapering now would tell us that the Federal Reserve believes the U.S. expansion is durable and that the global economy, at a minimum, is less fragile," said David Kelly, chief global market strategist at JPMorgan Funds.


Relatively less drama surrounds a decision later this week by the Bank of Japan, expected to keep in place its aggressive policy easing, and a European Union meeting where a long-awaited deal on a banking union could be struck.

In the world's third-biggest economy, the Japanese tankan survey is expected on Monday to show business confidence improved on the back of robust fiscal and household spending. The BOJ, whose monetary stimulus eclipses even that of the Fed, meets December 19-20.

In Britain, where the Bank of England has said it will not consider a rate-rise until unemployment falls to 7 percent, a report is expected on Wednesday to show the jobless rate was unchanged at 7.6 percent in the three months to October.

At the same time, minutes of this month's BoE meeting are expected to show policymakers stressing their message that rates won't rise automatically once the threshold level is hit.

In general the European recovery looks less solid than that in the United States.

Central banks in Hungary, Sweden and the Czech Republic are under pressure to ease policy further this week. Turkey's central bank could tighten policy - but that will be out of concern over the impact of a withdrawal of U.S. stimulus on its lira currency, inflation and current account shortfall.

Purchasing managers indexes for the euro zone, Germany and France should give a snapshot next week of the health of Europe's manufacturing sector.

EU leaders will try on Thursday to reach final agreement on agency for closing down failing banks in the euro zone, a crucial part of efforts to create a single banking framework for the currency bloc that would dampen any future crises.


All eyes, however, will be on the U.S. central bank's policy decision at 2 p.m. (7:00 p.m. British time) on Wednesday, just a week before the Christmas holiday. It is Bernanke's last press conference as Fed chairman and he is expected to stress that interest rates will remain low for a long while irrespective of when the quantitative easing programme, or QE, is shelved.

About half of the 60 economists polled by Reuters last week expected the Fed to wait until March before it trims the asset purchases, which are meant to spur investment and hiring. Twelve saw the so-called QE tapering this week, up from three when the poll was done a month ago.

While U.S. unemployment dropped to a five-year low of 7 percent last month, U.S. GDP growth is expected to stall this quarter as businesses cut inventories, complicating the central bank's decision.

"Timing the reduction in stimulus, while at the same time convincing the economy it's a good thing to do, is going to be challenging," said Jerry Webman, chief economist at investment manager OppenheimerFunds.

"Right now if you look at the U.S., Europe, China, and Japan, they all look to varying extents okay - but they're not accelerating."

(Additional reporting by Herbert Lash in New York; editing by Patrick Graham)