How U.S. and EU divergence on monetary policy will reverberate throughout the global economy

The U.S. Federal Reserve and the European Central Bank have come to a fork in the road when it comes to monetary policy, and this week each is expected to choose a different path.

Economists predict that ECB President Mario Draghi will announce an expansion of the bank's 60 billion euro quantitative easing program and another cut in its deposit rates on Thursday.

Meanwhile, the U.S. Federal Reserve is preparing markets for a potential interest rate hike at its Dec. 16 meeting. Fed chairwoman Janet Yellen will give a policy speech Wednesday and will provide testimony before the Joint Economic Committee Thursday.

The two diverge at a time when their economies are at opposite ends of the spectrum. While the eurozone struggles with high unemployment, weak inflation and near-flat growth, the U.S. economy has seen remarkable strength. That will leave Yellen no choice but to move the U.S. to higher interest rates.

“The general FOMC tone suggests a broad consensus to hike in December and with only a couple of weeks until the meeting, there is no room for ambiguity,” said Elsa Lignos, senior currency strategist at RBC Capital Markets. “We look for Yellen to stick to the hawkish leaning script.”

This is a pivotal moment for global monetary policy. If it plays out according to expectations, the decisions made will have a lasting impact on everything from exports, bond markets and the economies of both the U.S. and the eurozone for years to come.

“We expect the policy divergence between the ECB and the Fed to prevail for a considerable period of time,” said Michala Marcussen, an economist with Société Générale.

While she sees the Fed gradually raising its benchmark rate over the next few years, eventually reaching 2.75 per cent by early 2018, Marcussen expects that the eurozone will remain in the zero range throughout that period.

The ECB currently has its deposit rates set in negative territory at -0.20 per cent, meaning it charges other banks to hold money with it. The market is expecting that Draghi will cut deposit rates a further 10 or 20 basis points on Thursday.

While negative rates may seem counterintuitive, the ECB's hope is that making European banks pay for deposits will force them instead to seek out investments in the private sector, thereby boosting the eurozone's sluggish economy.

Of course, the divergent policies of the Fed and the ECB will have ripple effects on each other. A lower euro as a result of loose monetary policy will help make European exports to the U.S. cheaper — thereby helping European companies. It will have the opposite effect for American companies.

Already, some U.S. firms have said that the rapid gains in the price of the greenback against other major currencies have hurt international sales. The dollar index, which tracks the performance of the U.S. dollar against a basket of world currencies, has been sitting at a four-year high in recent months.

The Fed, of course, has no choice but to tighten despite the dollar's strength. This Friday's employment report is expected to seal the deal – economists predict it will show another month of strong job gains, highlighting an economy that is running at full steam and at risk of overheating without a rate hike soon. Current estimates say the economy will add 205,000 new workers in November, following a gain of 271,000 in October (which was the year's biggest monthly gain).

The unemployment rate is sitting 5 per cent, with the potential for it to slip to 4.9 per cent — the first time it would be that low since February, 2008, according to the U.S. Bureau of Labor Statistics.

A divergence of rates will have an important impact for investors. Stéfane Marion, chief economist and strategist for National Bank of Canada, said that while U.S. stocks have been a good bet in the past few years, that may change in 2016.

“We are eliminating our leaning to U.S. equities and raising our ante in emerging-market and Canadian equities, which are likely to gain lift in an environment more favourable to commodity prices,” he said. “Our 12-month targets remain 15,000 for the S&P/TSX and 2,200 for the S&P 500.”

Volatility could also be heightened in the coming weeks in the lead up to the Fed's Dec. 16 meeting. Mark Schofield, economist with Citigroup, notes that a rate hike is currently the overwhelming consensus, meaning the chance for volatility is high if Yellen and her team make a surprise no-hike decision.

“If policy rates do not diverge as much as expected, should perhaps, EM growth concerns spill over to the US, we might see some pain,” he said. “The most obvious place for that to be felt would probably be in currency markets where everyone seems to be long the USD. The dollar index has risen 8 per cent this year, in anticipation of Fed tightening. Our base case is that it has further to rise, but it's certainly one to keep an eye on.”

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