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The US Federal Reserve is stuck between a rock and a hard place with regards to winding down its quantitative easing programme. Carry on and it will inflate dangerous financial market bubbles, withdraw it and it risks causing a new financial crisis, which also poses a dilemma in terms of the direction of forex markets.

‘To taper or not taper’ that is the question. If the Fed goes ahead and starts reining in its quantitative easing programme that should be bullish for USD as it effectively represents a tightening in US monetary policy – though this has in part been anticipated. Next week’s FOMC meeting will probably see an announcement along the lines that it is going to be slowed down and this will further test the nerves of the forex markets. The Fed may try and couch such an announcement in dovish terms.

By Justin Pugsley, Markets Analyst MahiFX Follow MahiFX on  twitter

However, financial markets and many countries with large current account deficits had got used to living off the Fed’s easy money and the mere prospect of its withdrawal is already causing intense volatility for some emerging market and commodity currencies. India, Turkey, Brazil and Australia have all been adversely effected.

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Also China looks like it could be heading for some sort of financial crisis following years of over-investment, forced bank lending and excessive real estate and commodity speculation. The new Chinese leadership clearly wants to rebalance the economy onto a more sustainable growth path and this will require cleansing speculative excesses, but this could be considerably complicated by the Fed reining in its QE programme.

The hope is that the question of whether or not to taper can be resolved before January 31, 2014, the date that current Fed Chairman Ben Bernanke steps down. It appears he wants to start normalising US monetary policy before leaving, which is sensible. A new Fed chairman taking over during such a period of uncertainty is likely to cause a great deal of volatility – great news for forex traders, but a nightmare for policy makers.

The other factor is that the US recovery is not really that vigorous despite receiving the biggest monetary stimulus effort in its history. For instance, the improving unemployment numbers mask a falling rate of labour participation, which is worrying and something the Fed has acknowledged.

Even relatively strong real estate and auto sales, which have relied on cheap credit, could be chocked off by Fed tapering as it will lead to higher interest rates in the real economy and that impacts affordability for mortgages and car loans.

Unwinding the Fed’s QE programme without triggering another financial crisis, particularly in emerging markets, and keeping the US economy growing, is going to be challenging and will require some imaginative fine tuning by policy makers. The chances are that the issue over tapering will not be fully resolved in time for the hand over to a new Fed chairman or chairwoman.

The deep uncertainty that is likely to cause should favour safe haven currencies such as USD and possibly even JPY.