Fed likely to keep rates steady, signal on hold

CHICAGO (Reuters) - The U.S. Federal Reserve is expected to leave benchmark lending rates unchanged at its policy meeting on Tuesday and will probably signal that borrowing costs will stay steady for several months.

Since the Fed's last rate-setting meeting on August 5, the economy has shown signs of weakening while price pressures have begun to recede, cooling calls for rate hikes.

In addition, the possibility of a fresh bout of financial market turmoil, if emergency talks aimed at finding a buyer for investment bank Lehman Brothers LEH.N fail, could lead the Fed to look for ways to settle jittery nerves.

"They will acknowledge that the downside risks to economic growth have increased, that the financial markets remain fragile, and that the upside risks to inflation have eased slightly," said Steven Wood, an economist at Insight Economics in Danville, California.

Fed Chairman Ben Bernanke and his colleagues on the Federal Open Market Committee slashed benchmark overnight rates 3.25 percentage points to the current low 2 percent in seven steps between mid-September 2007 and the end of April.

Since then, two Fed meetings have come and gone with steady rates even as a sharp run-up in oil prices raised concerns on inflation. With oil prices now off the boil and financial markets far from settled, analysts have been confident the next meeting or two will bring a similar outcome.

If markets take a bad turn for the worse, however, the central bank could even hint at a willingness to lower rates.

DOVES COME HOME TO ROOST

A Reuters poll of 47 economists published on Thursday showed that the Fed is expected to keep rates steady through the first quarter of next year, before beginning to bump them higher. For details sees <ECILT/US>

While the steady-rate view is the widely held consensus, a worsening labor outlook has recently brought rate-cut pundits out of the woodwork, after several months when inflation hawks dominated the policy debate and markets were focused on when, not if, the Fed would tighten.

San Francisco Federal Reserve Bank President Janet Yellen and Boston Fed chief Eric Rosengren earlier this month aired new worries about the economy, taking special note of the fragile state of credit markets. A disorderly unwinding of trades should Lehman need to liquidate could exacerbate those concerns.

Yellen cited the risk a rapidly rising jobless rate could pull the rug out from under Americans, leading to more home foreclosures and causing banks to recoil further from providing credit -- a vicious, growth-dampening cycle.

The unemployment rate jumped to a five-year high of 6.1 percent in August, above the 5.5 percent to 5.7 percent that Fed officials had forecast for the final months of the year.

"Each passing week of higher (jobless) claims confirms our suspicions of a fundamental deterioration in the labor market," said Ethan Harris, economist at Lehman Brothers in New York. He looks for the Fed's next rate change to be a cut.

Just weeks ago, futures markets saw a rate increase as a near certainty by the end of the year. After the August jobs report, they have shifted to show a roughly one-in-three chance that the Fed will lower rates to 1.75 percent by then.

Should Lehman enter bankruptcy, calls for rate cuts are likely to become louder.

THE FISHER FACTOR

Minutes from the Fed's August meeting showed that many policy-makers were concerned longer-term inflation expectations could become unmoored, which could allow a cycle of higher inflation to become entrenched.

But the opposite has happened: expectations have cratered to multiyear lows as a gloomy outlook for global growth and bursting of a speculative bubble have sent commodities prices tumbling to the lowest levels of the year.

Inflation expectations shown in 10-year Treasury-issued inflation-protected securities are now below 2 percent for the first time since 2003.

"This is the fastest shift in long-term inflation expectations since late 2000, when the market rapidly rewrote the script from new-economy wealth creation to equity deflation wealth destruction," said Alan Ruskin, chief international strategist at RBS Greenwich Capital in Greenwich, Connecticut.

Against that background, Fed watchers are keen to see how outspoken inflation hawk Richard Fisher, president of the Dallas Fed, will vote on Tuesday.

In making a fifth straight dissent in August, Fisher noted that "businesses had become more inclined to raise prices to pass on the higher costs of imported goods and higher energy costs," according to the meeting minutes.

If he votes with the majority on Tuesday, it would be a sure sign that inflation fears are fading. But most analysts expect the Dallas maverick to hold his ground.

With core inflation likely to stay high for at least a few more months, the Fed's hawkish wing will likely argue strenuously against any wording in the statement that suggests the central bank is letting down its guard.

(Editing by Dan Grebler)