In comments made June 23 to Germany's Die Zeit but published only today, European Central President Jean-Claude Trichet warned of an "explosion" in inflation if the bank does not act decisively to counter it, Reuters reported Wednesday.

"If we are not resolute, there is a risk that inflation will explode. If we act decisively, then we can master the situation," Trichet said in the German text of comments published by weekly Die Zeit on Wednesday.

Trichet's comments appear one day before the ECB's meeting on interest rates. Many economists expect the ECB to increase its key interest rate, the refinance rate, by 25 basis points to 4.25%. (The ECB decision will be announced Thursday at 7:45 a.m. EDT.)

At issue: How to check inflation

European inflation is running at a 3.7% annualized rate, and trending up. That fact, combined with Trichet's comments published Wednesday, "all but guarantee a rate hike Thursday by the ECB," in economist David H. Wang's interpretation.

So much for consensus building.

That was how one currency trader characterized the present mood in the currency markets regarding the European Central Bank's upcoming Thursday July 3 meeting to discuss interest rates and monetary policy.

"Initially there was talk that [ECB President Jean-Claude] Trichet would make a concession to the doves, and hold off raising rates for this meeting, but now the belief pretty much is that they'll raise rates a quarter point to 4.25%," currency trader Andrew Resnick said Monday. Resnick added that he is short with the dollar in the euro-dollar and British pound-dollar currency pairings.

European inflation is running at a 3.7% annualized rate, and trending up, Resnick said, and "a 4% refinance rate just doesn't look like it can cut the mustard and contain inflation the way Trichet wants inflation contained." If the ECB increases the refinance rate -- its key, short-term interest rate -- it would be the bank's first increase in a year.

The U.S. Federal Reserve announced Tuesday an expansion of its securities lending program.

The actions announced today supplement the measures announced by the Federal Reserve on Friday to boost the size of the Term Auction Facility to $100 billion and to undertake a series of term repurchase transactions that will cumulate to $100 billion.

The Fed added that "since the coordinated actions taken in December 2007, the G-10 central banks have continued to work together closely and to consult regularly on liquidity pressures in funding markets. Pressures in some of these markets have recently increased again." The Fed added that central banks "will all continue to work together and will take appropriate steps to address those liquidity pressures."

"To that end," the Fed said, "today the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are also announcing specific measures."

Fed Analysis: Without question, the Fed is attempting to head-off any building, short-term liquidity crunch banks may face in the weeks and months ahead. This latest increase in the Term Auction Facility, the coordination with the other major central banks indicates monetary, and lengthening of the primary dealers' term to 28 days from overnight will help the Fed and the other central banks achieve that liquidity goal.

The U.S. Federal Reserve said that despite inflation concerns, "relatively low" interest rates may be needed "for some time," the central bank announced Wednesday in the minutes from its most-recent meeting. At the same time, however, the Fed raised its inflation projections for 2008.

"Several participants noted that the risks of a downturn in the economy were significant,'' the Fed said in minutes of the January 9 and 21 conference calls and the January 29-30 policy meeting last month. "Many participants were concerned that the drop in equity prices, coupled with the ongoing decline in house prices, implied reductions in household wealth that would likely damp consumer spending.''

Last week, in Congressional testimony U.S. Federal Reserve Chairman Ben Bernanke indicated that the Fed will lower rates further if financial conditions and the availability of credit deteriorate.

Also in the minutes, the Fed termed the inflation statistics since the end of the year, "disappointing." The Fed now expects 2008 core inflation of 2.0-2.2%, up from the previous 1.7-1.9% estimate.

Further, the Fed lowered its 2008 U.S. GDP outlook to 1.3-2.0% from the earlier 1.8-2.5%.

The selling in Europe continued before the markets staged a mild rebound -- which analysts attributed to short-covering and/or the U.S. Federal Reserve's action Tuesday morning to slash both the Federal Funds rate by 75 basis points to 3.50% and the Discount Rate by 75 basis points to 4.00%.

"The Fed's intervention...true, won't necessarily stop the selling that people are doing for fundamental reasons, but it will help calm the markets and reduce people's urge to sell because they fear the markets will freeze up....sell for fear reasons," London-based economist Mark Chandler told BloggingStocks on Tuesday.

There was also talk that the Fed's action will be coordinated with or followed by ensuing actions by the European Central Bank and the Bank of England to ensure the proper function of the markets, Chandler said.

At mid-day Tuesday, Europe's major bourses were down an average of 1% across the board. London's FTSE was down 24.90 points to 5,553.30, France's CAC 40 fell 56.86 points to 4,687.59, and the German DAX fell 147.32 to 6,642.87.

In response to the global equities sell-off and the likely pressure on U.S. stock markets when they open later today, the U.S. Federal Reserve slashed the Fed Funds rate by 75 basis points to 3.5% Tuesday morning.

The Board of Governors also approved a 75-basis-point decrease in the discount rate to 4%. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Chicago and Minneapolis.

The Fed said:

The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.

While the release said that "Appreciable downside risks to growth remain," it also mentioned that the committee expects "inflation to moderate in coming quarters." No doubt, the Fed has made its choice for now, preferring to stimulate the economy despite risking higher inflation. With lower oil prices -- caused by fears of lower demand as the economy slows down -- the Fed may have less to worry about inflation.

Has this move been enough? So far, futures indicate it may have been -- at least for today -- as their losses aren't as steep as before the announcement. Even with this Fed cushion, I'd expect the session to be bumpy.

When Ben Bernanke testifies before the House Budget Committee today, he's expected to announce his support for a short-term economic stimulus package, as long as it's based on measures that are quick and temporary, according to the New York Times this morning. He's told lawmakers he won't comment on proposals to link a stimulus package to the permanent extension of President Bush's tax cuts.

Finally some political sanity. I wish Alan Greenspan had taken that stance as President Bush continued to cut taxes during a war. If Greenspan had we wouldn't have added so much to U.S. debt and this country would be in much better shape fiscally to get us through the current credit storm.

Bernanke's support for the short-term fix is critical to getting many lawmakers to accept a stimulus package even if it means adding to the U.S. deficit. Without it, Congress probably could not pass a veto-proof economic stimulus package. President Bush would likely veto anything that doesn't include a permanent extension of his tax cuts to try to bully the Congress into continuing his economic folly - paying for a war on future debt. Our children certainly will hate us for a long time if we continue to ignore the burden we're putting on them.

The dollar plunged to a two-year low versus Japan's yen Tuesday, and retreated against other major currencies, on fears the U.S. economy has fallen into a recession, Bloomberg News reported.

The dollar fell 1.26 yen to 106.90 versus the yen. Meanwhile, the British pound rose about 1.5 cents to $1.9704 in mid-day Tuesday trading. The dollar was virtually unchanged versus the euro at $1.4862.

Economists and analysts say a recession in the United States would invariably drive the dollar lower, due to foreign investors' reduced demand for dollar-denominated U.S assets, many of which would underperform during a recession. The dollar also would be hurt by lower interest rates, a near-certainty in the months ahead, with the U.S. Federal Reserve widely expected to again cut benchmark, short-term interest rates to jump start the U.S. economy.

On Wall Street, there are forecasts...and then there are forecasts that investors/readers ignore only at their peril.

Put investment banking giant Goldman Sachs decidedly in the later category.

On Wednesday, Goldman Sachs (NYSE: GS) said the U.S economy is probably slipping into a recession, and also predicted that the U.S. Federal Reserve will cut its benchmark interest rate, the Fed funds rate, substantially, to 2.5% from 4.25% by third quarter, Bloomberg News reported.

Goldman, which projects an anemic 0.8% growth rate for the U.S. economy for all of 2008, also said it expects the Fed to lower its key interest rate to 3% by the middle of 2008, Bloomberg News reported.

To counteract the effects of the housing's sector's correction and other drags on the U.S. economy, including high energy prices, the Fed has cut benchmark interest rates three times since September.. The Fed Funds rate, the rate banks charge each other, now stands at 4.25%, and the discount rate, the rate the Fed charges banks for short-term loans, is at 4.50%. The Fed also set up a special term auction facility to help banks maintain short-term liquidity.

Federal Reserve Bank of Philadelphia President Charles Plosser indicated that further interest rate reductions may be needed to stimulate the U.S. economy, should economic growth become "substantially weaker" than already projected, Bloomberg News reported Tuesday.

"A substantially weaker outlook than expected, particularly if that weakness is projected to be more prolonged than anticipated, may require further adjustments to policy,'' Plosser said in a speech in Gladwyne, Pennsylvania, adding that he already expects several ``sluggish'' quarters of growth, Bloomberg News reported.

However, Plosser also told Reuters that he's "concerned that developments on the inflation front will make the Fed's policy decisions more difficult in 2008."

The Fed's preferred measure of consumer prices has risen 2.2% on a November 2006-November 2007 basis, or at a rate above the Fed's comfort zone, leading many economists to argue that the Fed may not be as stimulative as it typically would be at this stage of the economic cycle. The Fed may also continue to use non-interest rate policy options to encourage economic activity, these economists say.

It's beginning to look like the Federal Reserve has lost its independence. However, rather than taking dictation from the White House, it appears to be under Wall Street's control.

Bloomberg News reports that the Fed is likely to cut interest rates when it meets this week. Traders in federal funds futures initially gave a 75% chance of a rate cut on October 31, but scaled back those odds to 50% after the October 5 revision of August payroll numbers to show a gain instead of a decline.

The reason the Fed stated for its September 18 50-basis-point cut made little sense to me -- some words about market turbulence. The market turbulence is real enough -- related to the subprime mortgage mess -- about which I posted here. But the Fed's job is to keep inflation in check -- and with oil prices hitting a record $93 a barrel and labor rates rising at a 4.9% annual rate -- it is surely failing at that job. (Save me the blather about core inflation -- and excluding energy and food prices.)

However, Bernanke is responding dutifully to his Wall Street masters -- using the interest rate cuts to ladle a heaping dollop of corporate welfare onto the gilt-edged plates of billionaire bankers and hedge fund grandees.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.

I wrote yesterday about the recent Chinese veiled threat to dump its dollar holdings if the U.S. raises tariffs in hopes of coercing them to let the Yuan rise against the dollar. Today I had the opportunity to pick the brain of an expert on the topic, Brad Setser, Chief Economist at RGE Monitor and former acting director of the Office of International Monetary and Financial Policy at the U.S. Treasury.

My first question to him was, is this a credible threat? Setser didn't believe so, because it would represent a huge shift in China policy. The Chinese government, he explained, has shown a consistent bias toward supporting the country's exports, even at the cost of holding onto dollars as their value drops against other world currency. In fact, China continues to bolster its dollar holdings, adding $350-400 billion this year alone.

Setser went on to explain that, in his opinion, the Yuan was currently undervalued against the dollar by approximately 30%. If such an imbalance were abruptly corrected it would dramatically disrupt their export market.

He went on to say that China is in effect swallowing huge losses by holding dollars in order to support their exports, but the current regime has not indicated any likelihood to change that position.

However, he cautions, tensions between the two countries are growing, as the Chinese government takes umbrage at the growing movement in the U.S. to address the trade imbalance with legislation.

My take from this discussion: a change in the status quo is not in the offing, but the trade discussions in Congress are being watched carefully by the Chinese government. In the political season we are entering, pro-tariff campaign rhetoric could bring about more threats of reprisal.

Is our thirst for foreign capital about to bite us? According to a report in the U.K.'s Telegraph, officials of the Chinese government warn that they are prepared to dump their U.S. reserves onto the market should the U.S. government impose trade restrictions in an effort to persuade China to correct the Yuan/dollar imbalance.

China currently holds an estimated $900 billion in American bonds, and a total of $1.3 trillion worldwide. The warning is apparently a response to a bill backed by the Senate's Finance Committee that would impose tariffs to penalize China for currency manipulation.

This 'nuclear option', in the Telegraph's words, could be devastating to the already-weak dollar. However, as China's sugar daddy, such a blow to the U.S. economy would have vast repercussions on the Chinese economy as well. Any sane regime wouldn't take such a suicidal course of action.

So the question here, is one of sanity. Over the past decade, the Chinese leadership has shown many signs of economic savvy. One can only hope that the cooler heads prevail, and that this is simply brinksmanship aimed to carve out a better position in trade and monetary negotiations.

Analysis provided by Eric Buscemi of Theflyonthewall.com:

When Fed Chairman Bernanke took the helm of the Federal Reserve, it was refreshing to hear him say that the Fed would attempt to act more proactively. However, after hanging out with fellow board members, Bernanke is beginning to change his tune and sounds more and more like Alan Greenspan.

On Tuesday, Bernanke said policymakers want to see inflation continue to recede, suggesting the Fed probably won't be cutting interest rates any time soon. This means any proactive policy making decisions that he suggested when he took charge of the Fed will not occur.

Today, with massive amounts of top-down and bottom-up data to base decisions on, basing your decisions on inflation which is a lagging economic datapoint is just plain silly.

There is little evidence to suggest inflation is out of control and will not be decelerating during the next twelve months. Housing prices, oil, automobiles and everything technology-related will be cheaper in twelve months. The Fed Funds futures and the 10-year bond are all ready saying to start lowering rates.

Mr Bernanke, let's not act like Mr. Greenspan and act more proactively.