Fed set to slash U.S. rates as credit turmoil rages

CHICAGO (Reuters) - Faced with a raging credit crisis and an economy that may be mired in recession, the U.S. Federal Reserve looks set to cut interest rates sharply on Tuesday in a bid to avert a possibly severe downturn.

The scenario confronting the central bank is a thankless one: the threat of a deep recession comes even as inflation licks at the economy's heels. And no-one seems especially happy.

Fed Chairman Ben Bernanke is undergoing a "trashing ... by people who think the Bernanke Fed has eased too much, and those who think it has eased too little," said Ethan Harris, an economist at Lehman Brothers.

Bernanke and his colleagues have already lowered benchmark overnight rates by a cumulative 2-1/4 percentage points to 3 percent since mid-September. Tuesday's meeting comes exactly six months to the day from when they began chopping rates.

Forecasters, however, have turned increasingly gloomy on the economy in the past few weeks after a second monthly drop in employment, further signs of a consumer retrenchment and a financial crisis that led the Fed to throw a lifeline to Bear Stearns, the fifth-largest investment bank, on Friday.

In February, San Francisco Federal Reserve Bank President Janet Yellen warned a "negative feedback loop" could ensnare the economy. That fear may have been realized.

"Conditions have the potential to supercharge the increasingly visible self-feeding downturn in the real economy," Citigroup economist Robert DiClemente said.

Now, the only question seems to be the degree to which lingering inflation worries temper the central bank's move.

HOW DEEP A CUT?

The Fed has enacted a string of measures to stabilize credit markets, which need to function smoothly to keep the wheels of the economy turning.

Even before stepping in to rescue cash-starved Bear Stearns, it had pledged in recent days to pump $400 billion into the financial system to try to keep it from seizing up.

On Tuesday, policy-makers will turn their attention to their main tool to influence the economy -- interest rates.

Derivative markets that bet on Fed policy had recently wavered between a half-percentage point or three-quarter point cut in the federal funds rate. On Friday, dealers started to lean toward a bolder, full-point reduction that would take the rate down to 2 percent, the lowest level since December 2004.

"Aggressive policy action is warranted, and we expect officials to lower the funds rate by a full point ... Strong consideration ought to be given to an even larger reduction," said Citigroup's DiClemente.

Given the lag between rate cuts and their impact on the economy, there seems little incentive for a go-slow approach, with one major caveat: persistent and troubling price pressures.

THAT INFLATION THING

More hawkish Fed watchers are alarmed at the potential inflationary impact of the central bank's aggressive policy moves, which have helped drive the U.S. dollar to record lows and pushed up commodities prices in turn.

"Naysayers are apoplectic about the inflationary bias that aggressive Fed easing threatens," said Robert Barbera, an economist at ITG in Rye Brook, New York.

Martin Feldstein, president of the National Bureau of Economic Research, cautioned on Friday that inflation expectations, a litmus test of the Fed's anti-inflation credibility, could soon become unmoored.

A report on Friday, however, that showed consumer prices held steady last month offered some breathing room to the Fed.

"A credit crunch of the magnitude we are witnessing is inherently deflationary. Without access to credit, it's impossible for the U.S. economy to get the critical oxygen it needs to grow," said Bernard Baumohl, managing director at The Economic Outlook Group in Princeton Junction, New Jersey.

Officials could be split between those who expect an economic slowdown to cool inflation, and those who fear it will not.

Dallas Federal Reserve Bank President Richard Fisher, who voted against the last rate-cut decision on January 30, said on March 4 that the central bank could not "confidently assume that slower U.S. economic growth will quell U.S. inflation."

The Fed, however, may worry that too small a rate reduction could further upset jittery markets and imperil growth.

Economists at Goldman Sachs see two options on Tuesday: "Avoid disappointment at a delicate juncture by delivering a (full point) cut that keeps the Fed ahead of the curve, or stick with what appears to have been the earlier intent to cut by only (a half point) and promise more if needed."

(Editing by Maureen Bavdek)