The US economy has sailed through a series of rough patches, but the Federal Reserve is likely to cut interest rates Tuesday to guard against the effects of a brewing economic storm, analysts say.
The Federal Open Market Committee headed by Fed chairman Ben Bernanke is widely expected to trim its key federal funds rate, currently at 4.5 percent, by a quarter-point after cuts in September and October.
A few analysts say the Fed may make a bolder half-point cut, and some say policymakers may offer a bigger reduction in the discount rate, a heretofore little-used tool to loan directly to commercial banks when credit is scarce.
A decision is expected around 1415 GMT Tuesday.
Even though the world's biggest economy has managed solid growth over the second and third quarters of 2007, some analysts say the Fed must be prepared for a downturn in the face of tight credit and a worsening housing slump.
Scott Anderson, economist at Wells Fargo, said the central bank "needs to be forward-looking here, and despite signs that the economy today is still operating at a respectable pace."
Anderson added that the bond market, often seen as a harbinger of the economy is "still firmly in the recession camp."
"Banks are responding to the rise in their cost of funds and declining credit quality by shoring up their lending standards on a wide spectrum of products, prime and sub-prime mortgages, consumer loans and credit cards," he said.
"Historically, when banks begin to close the financial taps in such a broad way, the economy tends to land in a funk, if not outright recession."
"A mild recession is now likely," said economists Richard Berner and David Greenlaw at Morgan Stanley, citing the drying up of credit.
"Lenders and investors are tightening credit for commercial, credit card and auto lending, as well as for mortgage borrowers," they wrote in a note to clients. "We expect domestic demand to contract by an average one percent annualized in each of the next three quarters."
Friday's report on US payrolls showed 94,000 jobs were created in November. Analysts said the data is consistent with cooling economic conditions, as the economy needs to create between 110,000 and 140,000 posts a month to absorb new labor market entrants.
Some economists say the Fed may be considering a bold half-point cut to give a jolt of stimulus to credit markets and a faltering economy.
One way to jump-start bank lending may be to cut the discount rate by a larger amount to encourage the flow of credit, say analysts.
"We hope the Fed will lower the federal funds rate by 50 basis points and the discount window rate by 75 basis points and liberalize the rules," said David Kotok, chairman at Cumberland Advisors.
"We believe the credit market turmoil is continuing and that there is a growing contagion reaching beyond the banking system and into the general economy."
Joseph LaVorgna, economist at Deutsche Bank, says the US economy is holding up reasonably well so far but that the Fed is likely to cut rates as insurance against a downturn.
"The forecast we have is for modest growth at best, so the Fed is likely to err on the side of easing more rather than less," he said in a note to clients.
"Consequently, we continue to look for a 25 basis point cut in the fed funds rate."
But he said the economy is likely to avert a recession with the right actions from the Fed.
Another problem for Bernanke is that the FOMC is seen as divided after one dissent on the October rate move and other members openly worried about inflation.
Bernanke "is facing a challenging environment," said Mary Ann Hurley at DA Davidson & Co. "Bernanke likes to rule by consensus and the committee clearly has members who still see inflation as the major threat to the economy."
Bill Gross, managing director at Pimco Investments, said the bigger problem is the loss of confidence in the "shadow banking system" involving mortgage-backed securities and other similar assets.
"Central banks worldwide are facing a giant stress test of the modern-day shadow banking system," he said.
"Credit contraction, with its inevitable companion of asset destruction, is spreading with the speed of an infectious bacterial disease."
He said the Fed is likely to cut further "to stimulate a faltering economy" and that with inflation at only about two percent a federal funds "destination of 3.0 percent would therefore be a reasonable current target."
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