I know there have been some discussions on this but I found this thread which actually DOES work for getting an XP system to work from a USB.
(Not only the install but actually Booting and running). Ngine.de - How to install and run a FULL Windows XP from a USB drive
In theory something like this *could* work for Windows 7 --- anybody had a go yet.
Note - instead of Disconnecting Hard drives as specified in the link just disable them in the Bios - it's quicker and easier.
I know MS says its not possible but people seem to be able to find a way to do amazing things with computers.