The greenback was essentially range bound during Asian and early European trade as speeches from a number of Fed officials signaled a reluctance to aggressively ease monetary policy despite the softening tone of the US economy. Dallas Fed President Richard Fisher cautioned against placing too much weight on the employment data, noting that, “It is fair to say that I am encouraged by what I have heard against a background of constant negative speculation and the occasional discordant note, such as last week's employment numbers.”

San Francisco Governor Janet Yellen, one of the more influential Fed members, noted that that while market turmoil has the potential to hurt the economy, rate policy should not bail out investors. Clearly the Fed wants to keep all of its options open and does not wish the markets to pre-suppose its actions before the FOMC meet on September 18. Inflation remains a major concern of US monetary authorities as gasoline prices once again creep towards $3/gallon while news out of China suggests that pricing pressures in the world’s fourth largest economy are accelerating at a dangerous pace. Tonight’s report that Chinese inflation skyrocketed by more that 6% helped to send the Shanghai index tumbling more than 240 points. More importantly, China which for the past decade has acted as major deflationary force on the US economy, through persistently low cost exports, may no longer provide that benefit to US consumers. Given the fact prices for Chinese made goods which constitute a significant portion of US consumer spending, are likely to go up, the Fed must remain mindful of the inflationary pressures of this new dynamic.

At best US monetary policy makers hope that capital markets may stabilize as global growth offsets the negative impact of the collapse of the US housing sector. Furthermore, the Chinese who are extremely concerned about the PR value of the 2008 Olympics may act as the lender of last resort to calm the turmoil in financial markets and assure that global economic growth does not contract until after the Olympics are over. In short, this leaves the markets in an uneasy equilibrium between the bulls and the bears, as each camp watches for the next big shock to the system. For the time being the equity market continues to dominate FX flows, and should stocks rally, the carry trade will as well.

Boris Schlossberg is a Senior Currency Strategist at FXCM.