FOREX EUROPE UPDATE - USD

The dollar was mixed overnight, trading in a tight 1.2956-1.2975 range against the EUR and a weaker 121.25-121.75 range against the JPY.

Yesterday's data showed a rise in consumer confidence (probably still weather-related), and given the recent string of rather buoyant data, our economists believe there is little doubt the Fed will hold rates.

Additionally, the statement tone will probably continue to highlight risks to growth, which will keep the USD under pressure.

The recent performance of the US economy has raised expectations the Fed may adopt a more hawkish stance in its outlook - the implied yield on the May 07 Euro$ contract has risen 17.5bp since the beginning of the month.

However, with core CPI remaining weak, the case for tightening by the inflation-targeting FOMC is not strong and risks to growth still remain to the downside.

Our economists believe that the inflation indices contained in today's GDP report (released at 13:30 GMT) will likely reflect very weak headline inflation numbers-especially a 0.9% decline in the overall PCE price index-given the recent decline in energy prices.

The US housing market also continues to show signs of weakness, as yesterday the S&P/Case-Shiller home price composite 20 index showed the index fell at a 3% annualized rate over the past four months, compared with +11.8%y/y in H1(06).

As such, the Fed statement will likely again highlight continued weakness in the housing market and moderation in growth.

The other key event today is Paulson's testimony on the Treasury's semi-annual FX report and his December China trip at 15:00GMT.
Given the current fervour of JPY rhetoric in Europe and the new Democrat-dominated Congress, the risk is that Paulson will have to field questions not only on the perennial favourite China, but also on the weak yen.

While he is most likely to repeat Under Secretary Adams' assessment that Japan's cautious economic policy is appropriate, such pressure on the Treasury Secretary will reflect the broader sentiment in the US legislature.
Paulson's comments on the JPY should be watched. Nevertheless, we continue to think that lack of will in Japan and the US to address the weak yen issue would make it hard for the upcoming G7 meeting to have any lasting impact on the JPY or precipitate any sharp carry unwind.

Ahead today, key data include the full GDP report, Chicago PMI and the ADP labour report