Rate cut seen at intersection of Wall & Main

By Ros Krasny

CHICAGO (Reuters) - It's not just about Wall Street any more. A recent rush of weak data suggests the U.S. economy has entered a recession and that the Federal Reserve will vote to slash interest rates this month.

Antipathy toward Wall Street helped sink a $700 billion bank bailout bill in the U.S. House of Representatives on Monday, but since then it has become clear that Main Street is suffering amid a growing tide of joblessness and a factory slowdown.

Fed Chairman Ben Bernanke laid out the potential economic cost of seized-up credit markets in bleak testimony last week to lawmakers skeptical that an expensive government plan to unstick markets was needed for the economy as a whole.

"I believe if the credit markets are not functioning, that jobs will be lost, that our unemployment rate will rise, more houses will be foreclosed upon, GDP will contract, that the economy will just not be able to recover in a normal, healthy way," Bernanke said.

Dealers in interest-rate futures have barely looked back since Bernanke's comments. Futures markets now show more than a 90 percent chance that the Fed will lower the benchmark federal funds rate to 1.5 percent this month from its current 2 percent, and possibly further to 1.25 percent in December -- which would be the lowest rate since August 2004.

A month ago, futures were still leaning toward a rate increase by year-end, reflecting worries over inflation and optimism that the economy would start to rebound in the first half of 2009.

But optimism about growth has now virtually disappeared, driving up bets the Fed will have to cut rates.

"Weak economic data and a belief that even if (the bailout) becomes law, that a deeper and more prolonged economic downturn is likely ... is sending fed funds futures sharply higher," said Marc Chandler, chief currency strategist at Brown Brothers Harriman.

Economists at Goldman Sachs said they expect a recession slightly worse than the 1990 and 2001 recessions, but not nearly as bad as the 1973 and 1981 slumps.

They look for the U.S. jobless rate, currently at 6.1 percent, to peak above 7 percent by the end of 2009, and for the Fed to lower rates over the next three to six months.

TURN FOR THE WORSE

In recent weeks, the Fed has suggested a preference for keeping a firewall between its efforts to pump funds into financial markets to keep them liquid and shifts in interest rates aimed at the future course of the economy.

But with the economic downturn looking more severe than many suspected, it appears the Fed will have to reconsider.

On Thursday, a report showed initial claims for jobless benefits edged up to nearly 500,000 last week -- well into classic recession territory -- while a separate report showed factory orders sank 4 percent in August, the biggest decline since October 2006.

That followed an unexpectedly sharp decline in the Institute for Supply Management's factory index for September released on Wednesday, and dramatic declines in September sales at major automakers -- an outcome tied squarely to the inability of many Americans to obtain car loans.