Fed to mull rate cut but may hold steady course

WASHINGTON (Reuters) - The Federal Reserve will consider cutting U.S. interest rates to boost confidence in battered financial markets but policy-makers may keep rates on hold in the hopes that already low rates and expanded central bank lending will stabilize the economy.

Policy-makers started a one-day meeting at around 8:30 a.m., a Fed spokesman said. The U.S. central bank will announce its decision on interest rates at around 2:15 p.m.

The Fed has held the interbank overnight interest rate steady at a low 2 percent since April to help the economy recover from a deep housing market decline and sharp lending pullback.

But policy-makers are likely to be weighing the more than 500-point plunge in the Dow Jones industrial average on Monday, the index’s biggest one-day slide since September 2001.

The tumble in stocks followed a whirlwind weekend that brought the bankruptcy of 158-year-old Lehman Brothers Holdings Inc, the sale of investment bank Merrill Lynch to Bank of America, and a scramble for more cash by insurer American International Group Inc.

On Tuesday the storm showed little sign of letup, as investment bank Goldman Sachs said quarterly profits slid 70 percent and shares in Britain’s HBOS plunged by about a third. U.S. stock index futures hit session lows on the news about Goldman and lingering concern about the fate of AIG.

The MSCI main world equity index fell 1.7 percent, its lowest since December 2005.

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Markets fully expect a quarter-point Fed interest rate cut on Tuesday as indicated by short-term rate futures.

Some believed that if the Fed’s rate-setting Federal Open Market Committee decided to lower borrowing costs, it would do so decisively to send a convincing message to markets.

“If the FOMC does opt for a rate cut, 50 basis points is much more likely than 25 basis points, which would be seen as a token gesture in the current climate,” economists at Goldman Sachs wrote, adding they believe a no change in rates is the most likely outcome.

Policy-makers said at their previous rate-setting meeting August 5 that the Fed would act as needed if economic and financial developments posed a threat to sustainable economic development or stable prices.

The most recent financial turmoil is the latest in a series of shocks that began with the collapse in U.S. housing markets and a surge in U.S. mortgage delinquencies, many of them subprime loans made to borrowers with little ability to meet the terms of their loans.

The Treasury Department September 7 announced the government would take over operations of mortgage finance enterprises Fannie Mae and Freddie Mac, and was ready to infuse both institutions with up to $200 billion in capital if necessary to keep mortgage markets operating smoothly.

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While government officials made clear in recent days they would not use public funds to help Lehman avert bankruptcy, as they had done in March with investment bank Bear Stearns or with the mortgage enterprises, the Fed expanded its borrowing facilities to accept equities as collateral.

Since the credit crisis exploded a little more than a year ago, Fed officials have distinguished between special lending facilities established to ensure that money flows without interruption and interest rate reductions aimed at spurring economic activity.

Yet the severity of recent problems has led many to call for the Fed to go back to the most powerful weapon in its arsenal, rate cuts.

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Even so, many observers believe the Fed, which worried in August that inflation was high and that indicators of inflation expectations were elevated, will hold fire on borrowing cost reductions on Tuesday.

“To act now could interfere, slow or distract the private sector from undertaking the necessary steps to work out their problems on their own,” wrote Bernard Baumohl, an economist with the Economic Outlook Group in Princeton, New Jersey, on Monday.

In making any shift that would open the door to rate cuts, the Fed could cite a weakening economy and a more benign outlook for inflation. The labor market picture remains steadily dismal, with eight consecutive months of job losses and the highest unemployment rate in five years in August.

In the meantime, although inflation hit a 17-year peak in July, as measured by the year-over-year rise in the Consumer Price Index, crude oil prices have declined by 34 percent since highs in early July as global demand has slowed, offering some hope that prices will moderate.

Indeed, the CPI fell 0.1 percent in August from July as expected, a report released early on Tuesday showed, the first monthly decline in almost two years and a sign the slowing economy is relieving some inflation pressures.

Reporting by Mark Felsenthal; Editing by Diane Craft