With Street in upheaval, Fed rate cut is possible

John W. Schoen Senior producer • Profile • E-mail

Federal Reserve policymakers gather Tuesday for a regularly scheduled meeting that is suddenly anything but routine.

As recently as late last week, Fed Chairman Ben Bernanke and his colleagues were expected to leave short-term benchmark interest rates unchanged where they have been since April 30.

But the weekend upheaval on Wall Street — along with a sharp drop in oil prices — have led some analysts to predict the central bank will cut rates by a quarter- or even half-percentage point Tuesday.

Interest rate futures rallied sharply Monday -- indicating that investors believe a rate cut is more likely -- after the dramatic weekend that saw Lehman Bros. file for bankruptcy protection and Merrill Lynch agree to be taken over by Bank of America. Concerns over the stability of the financial system were aggravated by news that insurance giant AIG was struggling to raise capital to stay afloat.

Futures traders were betting the Fed will cut its key lending rate by a quarter point to 1.75 percent from 2 percent. A rate cut would help struggling financial companies and could give a boost to the stock market, which suffered its worst day Tuesday in more than six years.

Even if it doesn’t cut rates, the Fed has a bit of breathing room to signal that further cuts may be coming — a reversal after warning for months that higher rates may be needed to keep inflation in check.

The shift is possible because news on the inflation front has been improved substantially by the drop in oil prices, which have fallen by nearly a third since July. As a result wholesale prices fell 0.9 percent in August — the biggest drop in nearly two years. So-called "core" producer prices, which exclude energy and food, edged up only slightly.

Gains in productivity have helped keep the inflation genie in the bottle. And while the cost of raw materials has gone up, labor costs have not. That is helping take some of the pressure off business profits.

Still, Fed policymakers have to keep up their tough talk on inflation.

“The inflation outlook remains highly uncertain, not least because of the difficulty of predicting the future course of commodity prices,” Bernanke told a gathering of bankers in Jackson Hole, Wyo., last month. “And we will continue to monitor inflation and inflation expectations closely.”

After slashing the overnight rate from 5.25 percent to 2 percent — lower than the rate of inflation — policymakers have been counting on a slowing economy to help ease inflation pressure. A slowdown in the global economy also gives the central bank more room to maneuver.

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