All eyes on Fed ahead of next meeting

CHICAGO (Reuters) - A radical shake-up on Wall Street and heavy losses in financial markets have recast the debate for Tuesday's Federal Open Market Committee meeting to set interest rate policy.

Fed officials will assemble as a storm rages over the global financial system, overshadowing discussion of such bread-and-butter issues as the medium-term growth and inflation outlook.

As recently as Friday, analysts had expected the Fed to keep benchmark interest rates steady on Tuesday as it weighs a sputtering economy and an ebbing of inflation pressure.

On Monday, however, bets that the Fed will be forced into a quarter-point cut to the federal funds rate, to 1.75 percent from 2 percent, were rising. Dealers now see more than an even-money chance of a rate cut.

"Fed views have swung dramatically in response to the gut-wrenching developments," said Marc Chandler, currency strategist at Brown Brothers Harriman in New York.

The FOMC held rates steady when the panel met in June and August, after lowering them in April. That cut bought the fed funds rate down by a cumulative 3.25 percentage points from mid-September 2007.

Following are some factors policy-makers are considering:

FINANCIAL INSTITUTIONS:

Wall Street is in crisis mode. On Sunday, investment bank Lehman Brothers Holdings Inc LEH.N filed for bankruptcy, triggering fears of cascading losses across a range of financial institutions.

Lehman's demise came a week after the government crafted a rescue plan for U.S. mortgage finance companies Fannie Mae (FNM.N) and Freddie Mac (FRE.N), which had been brought to their knees by the housing market collapse.

Late on Sunday, the Fed announced a slate of measures to enhance its liquidity provisions and keep the financial system afloat as the global credit crunch, now in its second year, seems to be getting worse, not better.

U.S. stock markets were hit hard on Monday. The Dow Jones industrial average .DJI tumbled more than 2 percent.

ECONOMY TEETERS

The U.S. unemployment rate spiked to 6.1 percent in August from 5.7 percent in July, a surprise move to the highest level in almost five years. Employers cut payrolls by 84,000 nonfarm jobs for an eighth straight month of declines.

Revised figures showed second-quarter growth was a strong 3.3 percent as consumer spending got a lift from the government's tax rebate checks. But most pundits see the result as transitory and expect growth to slow again.

August retail sales were a bust. The closely watched core measure that strips out autos, gasoline and building materials fell 0.2 percent after rising 0.4 percent in July.

U.S. manufacturing remains on the cusp between expansion and contraction at a time when the reviving U.S. dollar could limit what has been a robust export market.

The Institute for Supply Management's index of national factory activity in August was 49.9 against 50.0 in July. ISM's non-manufacturing index clawed up to 50.6 from 49.5.

Durable goods orders, excluding the volatile transportation sector, rose 0.7 percent in July after posting a surprising 2.4 percent jump in June.

The Reuters/University of Michigan survey of consumers preliminary sentiment index for September was a strong 73.1, up from 63.0 the previous month.

INFLATION - A TURN IN THE TIDE

Inflation pressures have started to reverse since the FOMC last gathered.

U.S. crude oil futures hit $94.13 on Monday, down 36 percent from their record high of $147.27 per barrel on July 11. Similarly, the Commodity Research Bureau index is far off its highs and back to levels first reached in 2006.

Inflation expectations have fallen sharply. Ten-year inflation forecasts reflected in Treasury Inflation Protected Securities, or TIPS, are at the lowest level in five years at under 2 percent.

Plunging crude oil prices also helped push down consumers' one-year and five-year inflation expectations, which are part of the University of Michigan survey.

The consumer price index rose 0.8 percent in July for a 5.6 percent advance from a year ago -- the sharpest year-on-year rise since January 1991.

Core CPI, which excludes volatile food and energy prices, rose 0.3 percent and was up 2.5 percent on the year.

August CPI figures will be issued Tuesday morning. Headline CPI is forecast to fall 0.1 percent after August producer prices dropped a bigger-than-expected 0.9 percent.

HOUSING - STILL SUFFERING

Foreclosure rates are slowing a bit as measures to intervene in troubled mortgages take hold, and other indicators have been hinting the market is near a bottom.

Still, Fed officials have warned not to expect the housing sector to recover much this year.

Housing starts dropped 11 percent in July, reversing what was seen as an aberration in June, and are forecast to have slipped again in August.

Existing home sales in July rose 3.1 percent to a 5.0 million unit annual rate. But those sales came at a median price that was down 7.1 percent from a year earlier.

U.S. construction spending fell 0.6 percent in July after the previous month was revised to a small increase. Weakness in residential housing continues to overwhelm gains in public construction.

(Editing by Dan Grebler)