Although the US economy is no longer quite as dominant as it once was in the global economy, there is no sign that the Federal Reserve is losing its primacy among the major central banks – at least, not as far as the financial markets are concerned. In fact, the Fed is possibly even more important than it used to be, because it is now setting monetary policy not just for the US but for many other countries as well, via exchange rate links.

In a world where output is generally subdued and demand insufficient, no country wants to accept a rise in its real exchange rate. A global game of pass-the-parcel is underway, with many countries being forced to follow the Fed’s lead in monetary easing in order to prevent unwanted currency appreciation. Among other effects, this is clearly acting as a powerful support for equities and other risk assets at the moment.

At the last FOMC meeting on 10 August, the Fed worried the financial markets by sounding concerned about the economic outlook, while taking only a small step towards additional quantitative easing. Consequently, as the graph shows, all of the main risk assets fell quite sharply for a couple of weeks. This decline was only arrested when Ben Bernanke’s speech at Jackson Hole spelled out the Fed’s thinking on further monetary easing, after which “informed” financial opinion began to suggest that another big round of QE would begin before the end of the year. With US and Chinese economic data showing some improvement as well, risk assets rallied markedly.

The Fed faces a tricky decision tomorrow, Read more