Fed rate decision is key event for FX markets todayGBP/USD up following UK inflationBut gains would be limited by 'hawkish' FedOdds of a rate hike tonight rise againAmidst signs of easing banking stresses

Above: GBP/USD at one-day intervals.

The Federal Reserve is tipped by investors to raise interest rates by 25 basis points on Wednesday evening and push back against the market's growing expectation for interest rate cuts later in the year, developments that could limit the Pound's upside potential against the U.S. Dollar.

The Pound to Dollar exchange rate (GBP/USD) has been volatile over the past 48 hours amidst heightened investor uncertainty ahead of the Federal Reserve and Bank of England meetings.

The meetings come amidst high inflation rates in both the U.S. and the UK but signs of instability in the global banking sector could mean policymakers baulk at raising rates further.

GBP/USD was as high as 1.2284 on Monday as investors slashed the odds of a hike at the Fed to 40%, according to money market pricing. But fast forward to Wednesday and these odds have recovered to above 70% as investors become increasingly confident that the authorities in Europe and the U.S. had nipped a burgeoning banking crisis in the bud.

The Dollar rallied following news that the U.S. government was now exploring ways to protect all deposits in any bank that might come under pressure in the future; something investors reckoned would allow the Fed to hike interest rates again on Wednesday.

Treasury Secretary Janet Yellen meanwhile said on Tuesday that aggregate outflows from deposits at fragile banks had stabilised, "we see the situation as having improved."

The improved atmosphere and signs banking sector stresses are easing could allow the Fed to refocus efforts on fighting inflation again.

The rise in odds for a Fed hike pulled the yield paid by U.S. government bonds higher, which in turn boosted the Dollar and GBP/USD slid below 1.22.

But hotter-than-expected inflation data out of the UK on Wednesday have subsequently given UK yields, and the Pound, a boost.

Gains will likely prove limited if the Fed obliges markets with a 25bp hike and says further hikes are likely.

Above: Money markets show investors have drastically cut their expectations for the peak in Fed rates since the beginning of March. Image courtesy of Goldman Sachs.

"I think the Fed will acknowledge they're watching developments in the banking space, but they are far more reactive these days and set policy to what they can see in front of them – and the data supports a 25bp hike," says Chris Weston, Head of Research at Pepperstone, one of the UK's top-ranked FX brokers according to research by forex site CompareForexBrokers.

The U.S. Dollar could also strengthen if Chair Jerome Powell pushes back against the market's increased expectations for a number of rate cuts to be delivered by year-end.

The market currently expects up to 60bp of cuts to come from the Fed by year-end, more than any other developed market central bank.

"It's a toss-up between pause and 25bp, but these days the sting will be in the statement, the press conference and the updated forecasts and dot-plot," says Kenneth Broux, a strategist at Société Générale.

The dot plot is a chart that shows how each voting member of the FOMC expects interest rates to evolve in the future.

The Dollar could come under pressure if the March dots come down from the previous levels to the extent that it signals the Fed does indeed see the prospect of a rate cut later in 2023 or early 2024.

"In our view whether the FOMC does zero, 25bs or 50bps is less important than whether it conveys that it is close to a peak or sees open-ended risk of further hikes," says Steve Englander, Head of Global G10 FX Research and North America Macro Strategy at Standard Chartered.

"We see the continuity implied by 25bps this week and a stable year-end projection as the Aristotelian mean between 19th century Bourbon unresponsiveness to changed fundamentals and a complete retreat from the anti-inflation stance," says Englander.