Fed to weigh hit of credit crunch

By Mark Felsenthal

WASHINGTON (Reuters) - U.S. Federal Reserve officials meeting on Tuesday will grapple with how turmoil in financial markets and tighter credit may damage the economy, and could hint at some concern growth could falter.

The Fed is widely expected to hold overnight interest rates steady at 5.25 percent, where they have been for more than a year. The policy-setting Federal Open Market Committee is expected to release a statement outlining its views on the economy at around 2:15 p.m. on Tuesday.

Markets will watch keenly for any sign the U.S. central bank, which has persistently identified the risk of inflation as its main concern, is beginning to worry a bit more about the potential for an undesirable weakening in the economy.

The possibility of such a shift rose late on Friday as stocks tumbled sharply in the closing hours of trading after comments by a senior executive at investment bank Bear Stearns that credit conditions were the worst in two decades.

The Dow Jones industrial average .DJI closed down more than 281 points, or 2 percent, at 13,181.91. The blue chip index is off 5.8 percent from a record high close on July 19.

"The tightening in financial conditions combined with some likely further shading of growth estimates near term should prompt some new acknowledgment of downside risks," Citigroup economist Robert DiClemente said in a note to clients.

While some economists think the Fed might go so far as to put growth concerns on par with concerns on inflation, many others think officials will restate that inflation risks are their top worry.

EFFECT ON FUNDAMENTALS

The central bank has said turmoil stemming from a wave of adjustable rate mortgage delinquencies, while causing pain for many investors and homeowners, has not shown any signs -- so far -- of dragging down the broader economy.

"At this stage, the economic fundamentals are really unchanged" from how the Fed described the outlook in a report to Congress in mid-July, Fed Governor Randall Kroszner said on Thursday. "We have not seen an effect on the broader real economy. But we are looking very, very carefully at that."

The Fed's forecast was for steady if modest growth through 2007 and a pickup in 2008 as inventories of unsold homes become leaner, permitting a stabilization of the downtrodden U.S. housing market.

Friday's sharp stocks slide might persuade the Fed that housing market woes and problems with subprime mortgages are finally putting the broader economy at risk.

But while many investors saw in former Fed Chairman Alan Greenspan a willingness to respond to major financial market shocks by lowering borrowing costs, Chairman Ben Bernanke's Fed may be more reluctant to react to market events.

Fed Vice Chairman Donald Kohn said in May it is not the central bank's job to insert itself into natural cycles of "greed and fear that have always been with us, and the ebb and flow of competition for market share."

However, with extended turbulence in mortgage and credit markets, financial markets increasingly believe the Fed can no longer ignore risks to growth. Interest rate futures contracts have fully priced in a rate cut in October and imply a 70 percent chance of another cut by year-end.