By Kathleen Brooks, Research Director UK EMEA, FOREX.com

The ECB has been the most hawkish of the major central banks so far this year, but maybe not for much longer.

Yesterday ECB President Trichet hinted at a more dovish approach during testimony to the EU. He said that "risks to the medium-term outlook for price developments are under study" and will be updated at the next ECB meeting on 8th September when the next staff projections are released. This may suggest inflation expectations will be revised lower as the growth outlook has deteriorated.

Although Trichet said that "inflation in the euro area has remained elevated for some months," he added this was mainly driven by commodity prices. Brent crude oil is lower than its $126 per barrel peak in April, however, it currently remains elevated above $112 per barrel. The ECB will be watching developments at the Fed closely, if the US central bank announces more QE later this year, this could spark a rally in commodities (as it did during QE2), which would keep upward pressure on inflation in the euro area.

The hawkish stance of the ECB has been one of the factors supporting the euro, especially against the pound and the dollar. If the ECB shifts to a more dovish position then the euro may suffer against the majors in the medium-term as its loses its yield differential.

However, we don't expect a sharp reverse-turn in the ECB's thinking. It tends to be the most hawkish of the major central banks and is renowned for not tolerating inflation pressure. As we mentioned above there are still some upside risks to commodity prices so the ECB won't want to rush into a more dovish stance too quickly.

It's last staff projections for the euro area released in June 2011 stated:

• The current monetary stance is still accommodative
• Inflation is expected to remain above 2% for the rest of 2011
• The average inflation rate is expected to be between 2.5% and 2.7% in 2011 and 1.1% and 2.3% in 2012.

Back in June, the expectation was for domestic price pressures to rise (wages etc) as commodity prices fell, however, if growth continues to slow then tight labour market conditions may not materialise, reducing domestic price pressures going forward and weighing on the overall inflation rate.

Any changes to the 2012 outlook for inflation may move the market as investors try to price in the prospect of a more dovish ECB. However, we don't think that ECB will cut rates any time soon as this would 1, damage their credibility 2, there is no urgent need to cut rates since real interest rates (adjusted for inflation) remain negative.

We think instead the ECB will acknowledge the downside risks to their inflation forecast but will adopt a more cautious wait-and-see approach rather than an outright shift to a dovish stance at its September meeting.

Going forward the data points worth watching includes German wage growth, which has been rising at a faster clip than it has in the UK and US, along with inflation expectations as these are good indicators of domestic price pressure.

Chart source: Bloomberg

The views expressed are the author's, not FNArena's.

Disclaimer: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency or CFD contract. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. Any references to historical price movements or levels is informational based on our analysis and we do not represent or warranty that any such movements or levels are likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness, nor does author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.

Foreign Exchange and other leveraged products involves significant risk of loss and is not suitable for all investors. Increasing leverage increases risk. Spot Gold and Silver contracts are not subject to regulation under the U.S. Commodity Exchange Act. Contracts for Difference (CFDs) are not available for US residents. Before deciding to trade forex, you should carefully consider your financial objectives, level of experience and risk appetite. Any opinions, news, research, analyses, prices or other information contained herein is intended as general information about the subject matter covered and is provided with the understanding that FOREX.com is not rendering investment, legal, or tax advice. You should consult with appropriate counsel or other advisors on all investment, legal, or tax matters. FOREX.com is regulated by the Commodity Futures Trading Commission (CFTC) in the US, by the Financial Services Authority (FSA) in the UK, the Australian Securities and Investment Commission (ASIC) in Australia, and the Financial Services Agency (FSA) in Japan.

Technical limitations

If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

FN Arena is building the future of financial news reporting at www.fnarena.com . Our daily news reports can be trialed at no cost and with no obligations. Simply sign up and get a feel for what we are trying to achieve.

Subscribers and trialists should read our terms and conditions, available on the website.

All material published by FN Arena is the copyright of the publisher, unless otherwise stated. Reproduction in whole or in part is not permitted without written permission of the publisher.