The summer doldrums may not last for long with the Federal Reserve interest rate decision right around the corner. Over the past few weeks, many currency pairs including the EUR/USD and GBP/USD have been trading in a range as the market tries to figure out how central banks will respond to the continual rise in inflationary pressures.

After surprising the markets with hawkish comments on April 30, currency traders not only expect the Federal Reserve to pause on Wednesday, but to also raise interest rates before the end of the year. The tone of the FOMC statement and more specifically the degree of the Fed’s hawkishness will play a big role in determining where the US dollar is headed next. Dollar bulls will not be happy with anything short of unambiguously hawkish comments from the Federal Reserve. Anything close to a wishy-washy statement will be dollar bearish. For the dollar to continue to rally, markets need reassurance that rates will be increased over the next few months.

Federal Reserves Draws an End to the Easing Cycle

Although the market is primarily focused on finding forward-looking hints in the FOMC statement, traders should not lose sight of the fact that the Federal Reserve will be drawing an end to their 8 month long easing cycle. Since August, the central bank has cut interest rates by 325bp from 5.25 percent to 2.00 percent in an aggressive attempt to alleviate the credit crisis. Unfortunately the economy has not turned around but at the same time, a second major financial crisis has been averted. Even though the unemployment rate hit 5.5 percent in May, the biggest increase in more than 10 years, there hasn’t been another major blowup in the banking sector. Inflation on the other hand has gone through the roof as oil prices hit an intraday high just shy of $140 a barrel while corn prices hit record highs. Since the beginning of the year, crude oil prices have increased 45 percent while corn prices are up more than 60 percent causing companies across the nation to increase prices or add fuel surcharges. The Federal Reserve’s biggest fear at the moment is that these price increases will stick, meaning that these same companies who have increased prices will need a lot of convincing before agreeing to reduce them. That is why the Federal Reserve may be in such a rush to raise interest rates because once inflation sticks, it will be very difficult to reverse and because of that, the impact on growth over the long term can be more damaging than the impact of an interest rate hike. The futures market is pricing in at least two quarter point rates hikes before the end of the year.

How Many Rate Hikes are Priced In?

According to the latest Fed Fund futures, there is an 88.6 percent probability that interest rates will be at 2.25 percent on September 19th and a 67 percent chance that it will be at 2.50 percent on October 29th. Although the future contracts are pricing in a near guarantee of tightening before the end of the year, there has been a lot of speculation that the futures contracts are overestimating rate hikes because traders who were banking on 1.50 or 1.75 percent interest rates have been forced to reverse their positioning.

Will the Fed be Non-Committal?

The big question tomorrow is whether the Federal Reserve will be non-committal. Consumer confidence as measured by the Conference Board fell to 16 year low in the month of June. With 2 non-farm payroll reports and multiple inflation reports before the August meeting, the Federal Reserve may choose to buy themselves time by not signaling that a rate hike is imminent which is the primary risk for the US dollar. As indicated by the Fed Futures, traders have bid up the dollar over the past few weeks in anticipation of hawkish comments that would pave the way for a rate hike before the November elections. If those traders are disappointed, expect major dollar weakness.

Will the Election Year Prevent the Federal Reserve from Raising Interest Rates?

Also, it is a misconception that the Federal Reserve will not raise interest rates during an election year. The fear is that a rate hike could create unwanted political reverberations which could be legitimate if it wasn’t for the fact that the Federal Reserve is suppose to be independent. By law, the Fed’s monetary policy decisions do not need to be ratified by the President or Congress. Therefore logistically, the Fed should not be sensitive to the political environment, let alone succumb to political pressure. With President George W. Bush having already served 2 terms as President, he is not up for reelection, which reduces his inclination to meddle with the decisions made by the Federal Reserve.

On top of that rates have been raised before during election years. Over the past 4 decades, there have been 10 elections not including the upcoming one. In 7 out of the past 10 elections, rates were increased at one point or another during the election year. For example in 2004, when George W Bush was up for reelection, interest rates were 1% in January 2004 and at 2.25% by December. In 1988 during Reagan’s first election, interest rates were tightened from 14% to 20%.

As you can see, an election year will not stop the Federal Reserve from raising interest rates. If anything, they are actually more likely to raise interest rates during an election year than to leave them unchanged. Elections should not factor into the Federal Reserve’s monetary policy decisions and if it does, there is an even bigger problem at hand, which is the independence of the central bank.

The Fed’s job is focus on economics and not politics.

How Has the US Economy Changed Since the Last Fed Meeting?

Since the last FOMC meeting in April, most economic indicators continue to paint a grim outlook for the US economy. The manufacturing sector is no longer benefitting from the weak dollar and instead is feeling the sting of weaker growth. For the fourth month in a row, manufacturing ISM remained below 50, the barometer for contraction and expansion. Job growth was negative for the fifth month in a row while the Dow Jones Industrial Average hit its Bear Stearns lows. The primary dollar bullish news is on the inflation front which cannot really be counted as a positive for the US economy.

Skyrocketing food and energy prices continues to pose risks for the US consumer. Spending could tip over at any point and if it does, it would put a recession back on the table. Producers are still dealing with rising raw material costs and only a limited amount have been passed over to consumers. With companies like Dow Chemical announcing a 25 percent increase in prices, it should just be a matter of time before consumers feel more pain.

Dollar’s Fate Depends on Who is More Hawkish, Fed or ECB

The Federal Reserve and the European Central Bank have been battling out for the title of the most hawkish central banker. However the big drop in German business confidence and the first contraction in the Eurozone Composite PMI number since the series started in 2005 indicates that the ECB may only be a one hit wonder this year. Although ECB President Trichet warned that interest rates could be increased next month, slowing growth may prevent them from raising rates beyond 4.25 percent. Unlike the Federal Reserve, Eurozone interest rates are high because the ECB has not cut interest rates throughout the Fed’s easing cycle. As a result, there isn’t a significant amount of room to raise rates. At this point we are looking at only one rate hike from the ECB in contrast to the possibility of two or even three rate hikes from the Federal Reserve.

Will the Federal Reserve risk letting inflation stick? If they issue an unambiguously hawkish FOMC statement, it will validate the market’s call for more aggressive tightening, sending USD/JPY towards 110. Greater concerns for growth and a more convoluted statement on the other hand will draw the Federal Reserve closer to ECB, keeping the EUR/USD within its 1.5350 to 1.58 trading range.

Antonio Sousa is a Currency Analyst for FXCM.