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.
“I think they're gaining some flexibility,” said Robert Brusca, chief economist at Fact and Opinion Economics. “But they still need to sort of bang the drum and let people think that they're out there keeping the inflation rate down. So I don't think you'll see the Fed rhetoric turn over anytime soon. They're still going to warn about the risks that are out there."
But the Fed faces a parallel set of risks that may call for further rate cuts later in the year. The takeover of Fannie Mae and Freddie Mac helped calm credit markets but left unresolved a number of problems that continue to weigh on the banking system. The workouts of Merrill Lynch and Lehman Brothers over the weekend leave those problems unresolved.
“We didn't solve any problems for the guy who can't make the payment on his home,” said Richard Bove, a banking industry analyst at Ladenburg Thalmann. “We didn't solve any problems in terms of stabling housing prices. We didn't solve any problems related to figuring out how on a longer-term basis we're going to get more money to flow into the United States financial system. And those are the problems that have to be solved.”
European central banks — which have been raising rates to fight inflation — also are showing signs that easier money policies may be on the way. To calm jittery global financial markets, major European banks flooded the financial system with money Monday, hoping to avert the spread of anxiety over the Lehman’s collapse.
“Banks are likely to become even more reluctant to lend to each other, thereby increasing the risk that the credit crunch will deepen and last for considerable time to come,” said Howard Archer, chief European economist with Global Insight.
Until home prices stop falling, banks will have to keep marking down mortgage loans and related investments on their books. Lower mortgage rates may help the housing market, but the credit crunch has spread far beyond housing, according to Nouriel Roubini, an economics professor at New York University.
“At this point, it's not just housing: it's commercial real estate, credit cards, auto loans, student loans, leveraged loans, municipal bonds, junk bonds,” he said. “A huge credit and asset bubble has gone bust across the financial system, and now we have to pick up the pieces of it."
By keeping short-term interest rates low, the Fed can speed the recovery. Lowering the cost of money helps banks boost profits on new loans and make up for losses on outstanding loans.
Banks aren’t the only ones being battered. Consumers have seen much of their home equity melt away, along with the value of their retirement accounts, as the stock market has fallen more than 16 percent over the past year. Consumers are also finding it harder to borrow the money that used to provide a big boost to spending.
This summer’s tax rebate checks helped, but they have been largely spent or used to pay down debts. Retail sales unexpectedly dropped last month, the government said Friday.
With lenders getting tighter with new credit, consumers may have a harder time making ends meet.
“I don’t think that we’ve seen yet the full effect of the credit crunch because of the fact that people will not be able to borrow as easily or at the same price as before,” said Kathleen Stephansen, a global economist at Credit Suisse.
(The Associated Press contributed.)