Fed to slash rates as recession looms

By Ros Krasny

CHICAGO (Reuters) - The U.S. Federal Reserve is expected to cut lending rates at a two-day policy meeting this week in response to unprecedented turmoil in financial markets and the threat of a global recession.

The consensus among Fed watchers is for a half-point cut in overnight rates to 1 percent, which would be the lowest level since June 2004. The central bank is also expected to signal a willingness to lower borrowing costs again if needed -- especially with inflation pressures fading fast.

"The economic and financial stability backdrop could not be more challenging," said Robert DiClemente, chief U.S. economist at Citigroup. "The deteriorating economic outlook suggests still greater scope for action."

Fed Chairman Ben Bernanke and his colleagues, who gather on Tuesday and Wednesday, have already cut the benchmark federal funds rate to 1.5 percent from 5.25 percent over the past 13 months. They will announce their latest decision around 2:15 p.m. EDT (1815 GMT) on Wednesday.

The Fed held rates steady at its last policy meeting on September 16, but cut rates by a half-point on October 8 in an emergency move coordinated with other major central banks.

The sharp rate cut was complemented by other recent steps to create new funding facilities or expand existing ones to try to ease strains in credit markets that had become increasingly paralyzed by risk aversion, especially after investment bank Lehman Brothers failed in September.

The coordinated efforts have helped ease the global credit crunch, but baby steps on short-term money markets have been overwhelmed by bigger problems for the overall economy.

"The stabilization of the financial system, though an essential first step, will not quickly eliminate the challenges still faced by the broader economy," Bernanke acknowledged in congressional testimony last Monday.

WHEN DOVES CRY

A Reuters poll on October 16 showed economists predicting the U.S. economy would contract for three straight quarters, beginning with the third quarter that ended last month. Such a streak of declining gross domestic product would be the longest since 1974-75.

The U.S. Commerce Department will release its first snapshot of third-quarter GDP on Thursday, the day after the Fed announces its decision.

The U.S. labor market has shed jobs for nine consecutive months with no end in sight, while industrial output nosedived in September and consumer confidence has cratered, taking retail demand down.

The Institute for Supply Management's index of factory activity fell in September to 43.5, far into territory associated with recession, and regional indexes have suggested manufacturing activity has fallen further this month.

While retail sales dropped by 1.2 percent in September, a dramatic plunge in gasoline prices might salvage consumer spending in the final weeks of 2008 -- which would offer a rare bright spot for an economy the appears on a downward slope.

Gas prices have already been tracking the sharp drop in the price of crude oil, which has fallen by more than half since a record peak at $147 in July.