Fed funds futures are pricing in an 80% chance of a 25 basis point cut and a 20% chance of no move in the current 2.25% Fed funds rate. A month ago, the market was divided between a 25 or 50 basis point cut but more hawkish statements from voting members of the Federal Open Market Committee are believed to have erased the possibility of a half-point cut.

Camilla Sutton, currency strategist at Scotia Capital, said inflation concerns have been responsible for the shift in market sentiment. Along with a smaller rate cut, Sutton said markets widely expect the Fed to indicate a pause, or conclusion, of the rate cutting cycle.

"The market has swung so far to the camp they're cutting 25 and then going on pause, any kind of disappointment away from that and we'll see U.S. dollar weakness," Sutton said.

Sutton said the euro could rally to 1.5700 against the U.S. dollar if the FOMC statement doesn't signal a pause. The euro closed the day on Tuesday down 0.0094 to 1.5564 USD.

After hitting a record high of 1.6018 on April 22, the euro has weakened and Sutton said that it could fall another 1.5 cents if the Fed doesn't cut rates or indicates it might not cut at the next meeting.

"Should they either not go at all or signal a pause, I think we'll see a big downward move in the euro from here ... It doesn't mean it will be the end of the cycle, they might still cut in September or August, but it would be a dollar positive," Sutton said.

If the Fed takes a more wait-and-see approach, the euro will dictate the currency pair, Sutton said. "If it's a little bit left up in the air, we'll see moderate U.S. dollar strength for awhile and then the focus will really shift to Europe."

The recent turnaround in equity markets and improvement in credit markets have led many to believe the Fed could but wrapping up rate cuts and the U.S. dollar has bottomed out. The euro has gained 6.75% this year and 31.1% since the start of 2006 against the U.S. dollar.

A currency trader in Toronto told CEP News the U.S. dollar has started to recover in anticipation of a second-half turnaround.

""The Fed is still going to be concerned about growth, the economy and the credit crisis but in the past few weeks sentiment has really started to turn. There are signs the credit crisis is improving and that the Fed won't need to cut rates anymore. Inflation is a growing concern and I don't think the Fed can just keep cutting," the trader said. "You're going to see the U.S. dollar start to recover in the short term because there's a sense the U.S. economy has started to turn the corner. I think it will outperform in the next 3-6 months."

The market, he said, is heavily skewed towards some scenario that indicates a pause so if the Fed continues to cite downside factors in the economy, the U.S. dollar could suffer. "The risk is that if they're dovish you'll probably see a much bigger move the other way," he said.

He said a statement that points to more easing could "easily" spark a 2 cent rally in the euro against the USD, while a rhetoric indicating a pause might only bump the dollar towards 1.5500.

In a note to clients, RBC Capital Markets senior currency strategist Matthew Strauss noted the same skew.

"With the market already discounting a bottom in the Fed Fund rate at 2.00% -- and the possibility of a hike before year-end -- the upside potential for USD is limited," he wrote.

Although fed fund futures are pricing in a 20% chance of no cut, it would be a big surprise, according to Adam Boyton, a senior foreign exchange strategist at Deutsche Bank AG, the world's biggest currency trading firm. He expects to U.S. dollar to shoot up 0.5%-1.0% if rates are held steady but said it will later prove to be a selling opportunity.

"No cut at all would be quite supportive for the dollar on the day but ultimately I don't think that will signal the big turn in the dollar because we think the economy will suffer further and the Fed will cut further," he said, adding he expects the euro to hit 1.65 in 3-6 months as the Fed eventually lowers rates to 1.50%.

Strategists are divided on exactly how the Fed will signal that inflation risks have increased while still demonstrating the need to cut rates. They say knee-jerk market reactions to the decision may create opportunistic volatility.

In the past, the Fed has used a variety of ways to foreshadow a change in policy. Officials could cite the cumulative 300 basis points of easing since September and note monetary policy works with a lag, they could reference stabilizing market conditions or they could warn of rising inflationary pressures.

The Fed took a wait-and-see approach at the end of the rate hiking cycle that ended in June of 2006, saying, "The extent and timing of any additional firming … will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information."

Scotia Capital's Sutton said the market is hungry for a pause and will make an effort to read one into the statement.

"As long as it hints at a pause, that will be taken as a pause," she said.

The FOMC rate decision will be announced at 2:15 p.m. EDT on Wednesday.

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