Fed Prepares to Cut Rate to Fight Financial Crisis

The Federal Reserve is widely expected to cut interest rates by at least a half-percentage point on Wednesday in yet another move to turn around the credit crisis that is threatening the United States with a deep and prolonged recession.

The Federal Open Market Committee, the policy-setting arm of the U.S. central bank, began meeting at 9 a.m. as scheduled, a Fed spokesperson said. The Fed is expected to announce its decision on interest rates at around 2:15 p.m.

Ten out of 14 big bond firms polled by Reuters on Monday forecast that the Federal Reserve would lower the overnight federal funds rate target a half point to 1 percent.

That would be the lowest since June 2004 when the Fed was fighting a perceived risk of deflation, which some fear is about to reemerge.

Financial futures markets were gloomier on Tuesday, implying a 44 percent likelihood the Fed would lower borrowing costs by three-quarters of a point, which would take them to territory not visited since July 1958.

"With confidence flat on its back, the labor market weak, and credit markets still under intense strain, we expect the FOMC to announce a 50-75 basis point rate cut tomorrow," said Michael Darda, chief economist at MKM Partners in Greenwich, Connecticut.

A basis point is one one hundredth of a percent.

The U.S. stock market staged a rally on Tuesday as investors bet lower interest rates would help save the economy from weakening further, even though data showed U.S. consumer confidence sliding to a record low.

A report that Japan was set to reduce rates helped lift spirits.

How Low Will They Go?

The Fed has cut rates to 1.5 percent from 5.25 percent in eight steps over the past 13 months to counter a credit crisis that started with the collapse of the U.S. mortgage market and spread around the world.

The most recent move was a surprise half-point cut between regular meetings on Oct. 8 coordinated with a number of other central banks.

Some market participants think the Fed may be on the way to cutting rates to zero, just as Japan was forced to do to counter deflation in the 1990s.

Should Fed cut rates to zero? Watch video at left.

A more-forceful three-quarter point cut would be insurance against the risk of deflation.

But some analysts said that the lack of a clear deflationary threat at this point in time may lead the Fed to opt for the more-incremental half-point move.

"Given that deflationary forces from the collapse of the credit cycle have still not been seen, the FOMC may be reluctant to deliver a larger rate cut," said Marc Chandler, chief global currency strategist at Brown Brothers Harriman.

The statement the Fed will issue announcing its rate decision may also contain important hints on future policy.

Investors have already had a preview in the form of the statement issued on Oct. 8, saying market strain would crimp spending while inflation was fading as a risk due to weaker commodity prices and mounting U.S. economic slack.

Steep declines in the price of crude oil and other commodities are likely to drag the U.S. consumer price index down sharply in coming months.

Many analysts expect year-on-year readings of the CPI to fall into negative territory.

While this may not mean that broad deflation is setting in, it is likely to keep the Fed on high alert.

"Even if deflation is unlikely, officials will want to counter any increase in real interest rates as inflation tumbles," Morgan Stanley economists told clients on Monday, adding that a half-point rate cut was "virtually certain."

Real interest rates rise as inflation falls, tightening monetary conditions faced by borrowers even if policy remains steady.

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