Earlier today, both the Bank of England (BOE) and the European Central Bank (ECB) kept their short-term interest rates steady, as the fallout from the U.S. subprime market and tightening credit markets threaten to slow economic growth in these respective regions of the world.

The U.K.'s central bank left its overnight lending rate unchanged at 5.75 percent, while the European Union's central bank kept its key lending rate at 4.00 percent. Both banks had previously increased their short-term rates four times over the past year.

As a result of these actions, which most currency traders had expected, the U.S. dollar has rebounded against both the British pound sterling and the euro over the past few days.

However, you probably shouldn't expect this trend to continue for long because inflation rose significantly in Europe during August. In addition, rising commodity prices suggest inflationary pressures will persist over the near term. Hence, there's a good chance the European Central Bank will resume raising short-term interest rates soon.

Meanwhile, most economists and stock market participants expect the Federal Reserve to lower its overnight lending rate during its next meeting on monetary policy on October 31. (Note: Currency exchange rates tend to rise in countries where short-term interest rates are expected to increase and to decline in countries where rates are expected to fall.)

In addition to the effect that the likely future divergence in interest rate policies in the U.S. and Europe may have on the U.S. dollar, a largely unnoticed development is also negative for the direction of the dollar: Central banks throughout many regions of the world have been de-pegging their currencies to the dollar. As a result, institutional purchases of U.S. dollars have declined significantly over the past few months and net foreign purchases of U.S. Treasury notes and bonds declined during August by $9.4 billion — the most since January 2002 (see the chart below).

In light of the continuing war in Iraq — where approximately $750 billion dollars in government funds have already been spent over the past four years — and the slowing U.S. economy, any further declines in foreign purchases of U.S. Treasury securities could have a devastating effect on the U.S. economy.

Why? Because the U.S. government has essentially relied on borrowings from foreign investors to finance the war in Iraq, as well as domestic social programs. Hence, if foreigners continue to reduce their purchases of U.S. Treasuries, our government will either need to significantly raise taxes, or the Federal Reserve will need to reverse course and raise short-term interest rates in an effort to attract foreign investors to the U.S. markets. Either of these actions would likely assure the U.S. economy of entering a recession.

So, as you can see, the Federal Reserve is between a rock and a hard place. If it continues to lower short-term interest rates (in an effort to stimulate economic growth), the dollar will likely continue to decline against other major currencies and inflationary pressures will therefore rise. However, any further lowering of rates could force the Fed to later raise rates significantly in an effort to attract foreign investors to the U.S. bond markets.

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