Divergent interest rate expectation between the US and the euro zone has been the key driver influencing dollar movements in recent weeks. The dollar was sold off heavily after mid-June, reaching two-month lows against the euro and one-month trough versus a basket of major currencies in late June, on the view that the European Central Bank would hike rates in July to curb rising inflation pressures in the euro zone while the Fed was likely to keep rates on hold for longer as the US economy continued to lose momentum.

The ECB did deliver, hiking its benchmark rate by 25 bps to 4.25% after its meeting on July 3. However, ECB President Jean-Claude Trichet played down prospects of further interest rate increases, saying that the quarter-point move would help bring inflation back below its target of 2%.

His less than hawkish rhetoric disappointed euro bulls, sending the dollar sharply higher against the euro. Dollar sentiment was also boosted by the June US nonfarm report. While American employers cut jobs for the sixth straight month, the report was in line with market expectations. The dollar rallied sharply against all majors as a result,

It is difficult to see a clear trend for the US dollar going forward. Central banks, including the Fed and ECB, are in a dilemma. They should be hiking rates to curb inflation, but their weak economies are crying out for more monetary stimulus. The Fed is on hold for the time being as it hopes that inflation would recede eventually to more normal levels. However, if reality is different, it may be forced to hike and the dollar could score across the board gains. One thing is sure, though, volatility is here to stay.

Central banks around the world have to deal with rising inflation risks as energy prices scaled new heights and food prices kept on increasing.

The European Central Bank hiked its benchmark interest rates as expected by 25 bps after its latest meeting on July 3, to bring its benchmark rate to 4.25%. The ECB has been more hawkish all along. It did not follow the Fed to cut interest rates even though many euro zone economies were affected by the global credit crisis.

In contrast, the Fed has been more aggressive in easing, slashing the fed funds target rates by a total of 325 bps and the discount rate by 400 bps since August 2007. But with headline inflation and inflation expectations rising, Fed members decided that it was time to pause. They kept the US benchmark rates unchanged at 2% at their two-day meeting on June 24-25. The pause was the first in the current easing cycle.

While the statement issued after the meeting was more hawkish than those in the past, it was not as hawkish as the market had expected. Committee members still saw inflation as a temporary phenomenon, expecting it to "moderate later this year and next year". In addition, they cannot ignore the poor state of the US economy, especially as recent releases point to rising unemployment and persistent weakness in the housing market. What the Fed has done is to give itself the flexibility to dictate policy based on incoming data.

Looking ahead, Fed policy makers are likely to maintain their anti-inflation rhetoric as an attempt to keep inflation expectations in check through strong words. It is, however, unlikely to put word into action and raise rates unless there are clear signs of pass through of headline inflation into the economy. In the event, we expect the Fed to keep rates unchanged at 2% until the year end.

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