Fed Is Facing Growing Pressure to Cut Interest Rates

Growing worries about a world-wide credit crunch are fueling speculation that the Federal Reserve may be forced to abandon its anti-inflation stance and cut interest rates.

Traders already are betting that the Fed, along with other central banks around the world, will  have to start easing credit sooner than later. That's particuarly true if the current efforts to inject liquidity into the banking system fail to stem the credit crunch.

"Most recent communications from these central banks have signaled that tightening remains on track," JP Morgan economists David Mackie and Bruce Kasman wrote in a note to clients. "However, developments in financial markets are placing these calls on watch as continued turbulence has the potential to change central bank behavior quite quickly."

Investors have slashed bets for euro-zone and Japanese rate hikes since Thursday on fears that widening problems in credit markets will undermine strong global growth.

Market pricing for a European Central Bank rate hike next month has dropped to less than 50 percent and the chance of a move this month by the Bank of Japan has halved to 35 percent.

Meanwhile, the probability of a U.S. rate cut by the end of September has surged to 75%, with a one-in-three chance of an emergency cut to rates before the next scheduled meeting.

Key to central banks' dilemma is balancing concerns about inflation against the need to prime markets with enough funds to keep running if panicked investors keep money out of circulation.

But some economists said the Fed had felt for a long time that credit risk was being priced too cheaply in financial markets and signaled at its policy meeting on Tuesday that recent market turmoil had not altered its view.

"The Fed made a clear statement this week that market difficulties were not enough to derail their baseline economic view and I don't think that what has happened since will have changed that," said former Fed economist Dean Maki, chief U.S. economist with Barclays Capital in New York.

The Fed said on Tuesday that while downside risks to growth had increased due to tighter credit conditions and volatile markets, the economy's moderate expansion remained on track.

© 2009 CNBC.com