The European Central Bank is widely expected to leave rates steady this week at 4.00%, but the big question for the markets is: will he remain hawkish or focus more on mounting downside risks to growth? Estimates for Euro-zone CPI during April did ease to 3.3 percent from 3.6 percent, but this is still well above the ECB’s 2 percent target, and as a result there’s little doubt ‘price stability’ will be the foremost concern for Trichet. However, if he suggests that price pressures will moderate in the near-term – as they have recently started to do – or that feeble financial market conditions and the US economic slowdown are a major threat the Euro-zone growth, the euro could actually sell-off across the majors on Thursday.

US Fed: Credit Markets Will Likely Remain A Problem, But Rate Cut Cycle May Be Over

As expected, the Federal Open Market Committee reduced the target fed funds rate by 25bps to 2.00% last week, but there were indications that the current rate cut cycle may be nearing an end. While the FOMC clearly remains concerned about the economy, the Committee said for the first time that their past easing of monetary policy “substantial.” This comment along with concerns that “inflation expectations have risen” and removal of the phrase saying that "downside risks to growth remain" suggests that steady rates may be on the way. However, lingering credit market concerns following the announcement of multi-billion dollar losses at Fannie Mae and UBS is keeping hopes alive for more accommodative policy in at the FOMC’s next meeting. Nevertheless, futures are currently only pricing in a mild 16% chance of a 25bp cut in June, with the odds in favor of the target fed funds rate staying pat at 2.00%, as the FOMC will likely continue to try to confront liquidity issues with expanded lending facilities like TAF and TSLF.

FOMC Policy Statement

“Recent information indicates that economic activity remains weak…Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters…Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months…The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity.” – April 30, 2008

Ben Bernanke, Federal Reserve Chairman

“…conditions in mortgage markets remain quite difficult, and mortgage delinquencies have climbed steeply…Many foreclosures are not preventable…high rates of delinquency and foreclosure can have substantial spillover effects on the housing market, the financial markets, and the broader economy.” – May 5, 2008

Henry Paulson, US Treasury Secretary

“I've got confidence in the Fed and I've been very supportive of what the Fed has done and what the Fed is doing. As you've heard me say many times, I'm a strong dollar man, we have a strong dollar policy and although our economy, which has got some ups and downs, and is going through a rough patch right now, I think our long-term economic fundamentals compare very favorably when I look around the world and I think they're going to be reflected in the value of our currency.” – May 1, 2008

ECB: Will Trichet Back Off From His Hawkish Bias This Week?

The European Central Bank is widely expected to leave rates steady this week at 4.00%, but the big question for the markets is: will he remain hawkish or focus more on mounting downside risks to growth? Estimates for Euro-zone CPI during April did ease to 3.3 percent from 3.6 percent, but this is still well above the ECB’s 2 percent target, and as a result there’s little doubt ‘price stability’ will be the foremost concern for Trichet. However, if he suggests that price pressures will moderate in the near-term – as they have recently started to do – or that feeble financial market conditions and the US economic slowdown are a major threat the Euro-zone growth, the euro could actually sell-off across the majors on Thursday.

Jean-Claude Trichet, European Central Bank President

“What we are observing in the first quarter of 2008 is that the economy was quite robust and in the first half of the year it will probably be reasonably resilient.” – April 30, 2008

“On a global level, inflationary risks are significant...There is no time for complacency for central banks in any respect...the present level of inflation must be transitory.” – May 5, 2008

Erkki Liikanen, European Central Bank Governing Council Member

“Food prices are an issue everywhere for two reasons: First, the impact on inflation, and second, the impact on the situation of many poor people around the world…It is a challenging situation for developing nations.” – May 5, 2008

Nicholas Garganas, European Central Bank Governing Council Member

“Inflation expectations in the euro zone have remained "firmly anchored" around the European Central Bank's definition of price stability since the central bank's inception.” – May 1, 2008

“The success of the ECB’s monetary strategy is borne out by its record. Since the inception of the euro area, average inflation in the euro area has been 2.08 percent, a shade higher than the ECB’s definition of price stability. Inflation expectations have also remained firmly anchored around the ECB’s definition of price stability, attesting to the ECB’s credibility. Long-term interest rates have been at historically low levels” – May 1, 2008

BOE: Another 25bp Cut? Close, But No Cigar.

Like the ECB, the Bank of England is expected to leave rates steady this week at 5.00%. However, given the fact that the vote for the April rate cut included six in favor of the 25bp reduction, two votes for no change, and one vote for a 50bp cut, it’s clear that there is major disagreement amongst the Committee on what their next move should be. Inflation pressures in the UK have not been quite as strong as in the Euro-zone, though CPI is still above MPC’s comfort zone, and in the Bank’s Financial Stability Report they tried to put a positive spin on the credit crunch by saying it was “needed after the credit boom and was bound to have costs.” However, the MPC also noted major risks from a plunge in commercial property values, which could lead to significant losses for UK banks on losses related to commercial mortgage-backed securities (CMBS). This has stoked concerns that the UK is in for a US-style property market collapse, or worse, an all-out recession. As a result, we will likely see at least a few votes in favor of another 25bp reduction, but with BOE Governor Mervyn King forecasting CPI above 3% in the next year, inflation risks may loom too large for the majority of members to actually enact a cut.

Mervyn King, Bank of England Governor

“It is likely that inflation in the next 12 months will hit 3 percent and possibly higher, because of the impact of higher food and energy prices. And the Committee have judged that it would not be sensible to raise interest rates significantly at this stage in order to induce a recession to try and keep inflation below 3 percent. As long as food and energy prices don't continue to rise at the same rate, they can stay at these high levels, inflation would fall back.” – April 29, 2008

John Gieve, Bank of England Deputy Governor

“The unavoidable correction after the credit boom is proving protracted and difficult. While there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months.” – May 1, 2008

David Blanchflower, Bank of England Monetary Policy Committee Member

“I have simply tried to look at the data and suggest there are potential risks to the downside which we need to be careful of. That's a risk to inflation in the medium term, and I think people are focused too much on inflation in the short term.” – May 1, 2008

“I believe more action is needed to prevent the UK falling into recession. Monetary policy in my view still remains restrictive currently, and we need to take action to loosen policy sooner rather than later. I do feel that the slower rates fall, the further they will eventually have to go down to boost the economy.” – April 30, 2008

“Developments in the UK are starting to look eerily similar to those in the United States six months ago. There has been no decoupling of the two economies; contagion is in the air.” – April 30, 2008

Richard Lee is a Currency Strategist at FXCM.