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Why the Fed should always be in focus: O'Neill

There are many risks to the world economy and financial markets. While some of them are common to both, some are only relevant for the markets -- and they might be a consequence of economic improvement, or at least perceptions of them.

As has been observed during the summer, a large variety of geopolitical risks have dogged the world, including the remarkable events in the Middle East and the worrying conflict in Ukraine. All of these risks have the potential to deteriorate further and disrupt markets and economies.

Mladen Antonov | AFP | Getty Images

For example, the German economy has already shown some softening as a result of its close export ties to Russia. This could still be an issue as the year goes on and the Russian incursion in Ukraine escalates, adding to the already troubling evidence of a weak euro zone economy.

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However, what is a much bigger risk for global markets is ironically one that could emerge from a continued improvement in the U.S. economy and with it, further declines in unemployment. These factors could put pressures on the U.S. Federal Reserve to accelerate its current plans of exiting its monetary generosity.

For a long time, I have followed the U.S. weekly job claims as a good short- to medium-term leading indicator of the underlying employment market, and this has been the case again in the past couple of years. In recent weeks, the improvements have continued, and weekly job claims are now starting to move below 300,000 on a regular basis, taking us into a new range. If this continues, the Fed is probably going to start sending stronger signals that interest rates will be on the turn in 2015.

As we saw in a small sign in the second half of 2013, higher short-term interest rates could have a consequence for financial markets all over the world -- whether they be domestic US equities, the bond markets of other developed economies, the value of the dollar and the performance of many emerging markets.

Given the very long years in which monetary policy has been easing and investors have been searching for higher yields, there has to be a significant risk of exit from these markets given the still predominant influence of the dollar. Of course, it won't necessarily follow that this will result in disruptive consequences and investors have certainly had plenty of time and warning that this could happen. But despite this, it would be foolhardy to not think some disruptive consequences could occur.

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For some parts of the world where economic performance has continued to be weak, such as the euro zone, and some emerging nations such as Brazil and Russia, the end of U.S. monetary policy easing would be an additional challenge and might need governments and central banks to act to offset some of the effects.

Indeed, to cope with cope the end of U.S. quantitative easing, and implement its ongoing structural challenges, the euro zone might have to make its own risky decision and drop the German-driven focus on fiscal austerity.

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Just to be clear, I would not describe these risks as at all my main scenario but I do think that as markets have continued to rise, any forces that bring this performance to an end, in particular shifts in US monetary policy, might lead to unpleasant consequences.

Jim O'Neill is an investor and former head of global economic research at Goldman Sachs.

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