The markets are bracing for the Fed's moment of truth

If 2014 has been a year characterised by a fixation with commodity prices, 2015 is shaping up as a year where currencies are going to get a disproportionate share of the attention.

This week's final Federal Reserve board open market committee meeting for the year produced a subtle change in the language the committee has been using in relation to its expectation of when it might start raising official US interest rates.

Where the committee had been saying that it would hold the Fed Funds rate near zero "for a considerable time", this week it said that it judged that it "can be patient in beginning to normalise the stance of monetary policy".

While it also said the change of language was consistent with its previous statement -- the use of "considerable time" -- the obvious interpretation of that shift in language is that the passage of time means that the moment of normalisation has drawn nearer.

The market expectation is that the Fed will begin raising rates in the middle of next year and that the path of US rates will follow a gentle and measured rise in small increments before achieving normality sometime in 2017.

Should the first hike come a little earlier than expected, or the pace at which US rates are normalised be slightly faster than the market is anticipating (the market appears to be pricing in only a couple of 25 basis point increases next year), there could be some shockwaves through global financial markets and economies.

We've already seen that a relatively modest appreciation in the US dollar has sent ripples through the global system as capital has flown back from emerging market economies towards the US in expectation of further appreciation in a self-reinforcing cycle.

A lot of the capital that has flowed towards developing economies during 'risk on' periods in markets has been via various types of collective investment vehicles -- hedge funds, ETFs and mutual funds -- which creates volatility and leveraged effects when investors want to repatriate their investment exposures.

There's an additional layer of leverage associated with the US dollar because a lot of emerging market corporate debt -- perhaps as much as $US2 trillion if the Bank of International Settlements' data is correct -- has been raised via US dollar-denominated borrowings.

As the dollar strengthens against their home currencies it creates asset and liability mismatches and enlarges the debt-servicing and repayment burden and increases the prospect of an increased capital flight to the safety of the US.

It also increase the prospect of destabilising 'currency wars', whether deliberate or simply as the flip side of US dollar strength. Previous periods where the US dollar has strengthened quickly have coincided with crises in emerging markets, like the Asian crisis in 1997.

Given the unconventional monetary policies that will still be pursued by the eurozone and Japan in 2015 and the spluttering within China's economy there is potential for further significant devaluation of the euro and yen against the dollar, while China's peg against the dollar, while somewhat looser than it once was, could add another challenge to those already confronting its policymakers.

As the moment of truth for US monetary policy draws nearer, it could inspire greater volatility and a fresh bout of unintended consequences in financial markets.

If an unintended consequence of US quantitative easing has been speculative flows out of the US into emerging markets and commodities, a reversal of those flows would see them pour into US equity and bond markets, which are arguably already inflated because investors are discounting risk in their search for returns.

The prospect that the US dollar might overshoot, and that US monetary policy might promote new asset bubbles within the US economy, would complicate the Fed's approach to normalisation.

It won't want to undermine the competitiveness of US corporates by allowing the dollar to strengthen too much too quickly nor risk inflating financial bubbles that would force it to raise rates more aggressively than it would prefer.

Last year when the markets experienced a taper tantrum, we saw how sensitive markets have been even to changes to the nuances of the language the Fed uses. When it moves from talking to acting the potential for much-increased volatility and large-scale unintended consequences could be magnified.

The eventual start of the normalisation of US monetary policy -- in itself a good thing because it signals the gradual return to health of the US economy -- was always going to be a delicate moment for the global financial system and real economies.

Having already had a taste of what might be to come as markets have begun anticipating that moment, 2015 shapes as a critical moment in the post-crisis period and another potential flashpoint for a still-vulnerable and volatile system.

The Fed carries a weighty responsibility for navigating through a very complex and potential destabilising maze of the conflicting pressures it will have to take into account next year. The rest of the world may have to grapple with serious volatility as a new post-crisis financial and economic context starts to emerge.