On Tuesday, dollar bulls were hoping the Federal Reserve would take a hawkish stance on inflation and signal that an interest rates hike.

That didn’t happen. Instead, the Fed issued a fairly neutral statement. It said “downside risks to growth remain” - dropping a reference in June’s statement to “diminished” dangers - and price increases are of “significant concern.”

Chris Gaffney in The Daily Reckoning says the statement indicates the Fed realizes it will be forced to leave rates untouched. This leaves Mr. Market is to focus on the European Central Bank. Expect more inflation fighting from Jean-Claude Trichet and his pals…

The Eurozone has been posting some pretty poor numbers. Just this morning Germany reported that factory orders in the second quarter dropped for a seventh straight month in June. Manufacturing has slowed in Germany and Europe, as a stronger euro (EUR) has weighed on demand for exports. The continued slowdown in German industrial production increases the likelihood that the Eurozone is slipping into a recession.

But the ECB has never wavered from their mandate for price stability. This dogged fight against inflation will help maintain the long-term value of the euro. This latest dollar rally just doesn’t make sense when you look at the overall global economic picture. Yes, growth in the Eurozone is slowing, and Germany may be slipping awfully close to a recession, but the United States IS in a recession! And while the impotent FOMC sits back and ‘hopes’ that inflation will abate, the ECB has had the courage to continue its fight against inflation.

The past month has been hard on holders of foreign currencies, but investors have to look past this dollar correction. Only three major currencies have outperformed the euro since the beginning of 2008: the Brazilian real (BRL), Mexican peso (MXN), and Swiss franc (CHF). In the long run, I have to believe the inflation fighting of a strong ECB will help to maintain the euro’s value versus the U.S. dollar.

So today the markets’ focus will shift to the upcoming BOE and ECB interest rate meetings. ECB President Jean-Claude Trichet is expected to keep interest rates unchanged, but may signal that higher interest rates will be needed to combat inflation. Trichet will hold a press conference after the ECB announces its decision tomorrow, at 1:45 PM in Frankfurt. The currency markets will be listening to his every word, trying to uncover any indications of a change in his hawkish stance against inflation. Until then, the dollar will likely remain in a fairly narrow trading band versus the euro.

The Bank of England is also expected to keep rates unchanged, but the pound (GBP) will likely continue to come under pressure as many feel the BOE has been ineffective in its policy decisions. U.K. consumer confidence fell the most in at least four years, as England deals with a housing market slump that rivals our own. The markets have lost confidence in the Bank of England’s ability to deal with the current economic situation, and the pound continues to fall because of it.

P.S. To get The Daily Reckoning sent directly to your inbox, sign up for our free email newsletter, or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.

Source: Fed Not as Hawkish as Expected