Just a few days ago, a rate cut appeared largely off the table. Now it has emerged as a possibility as the Fed prepares to meet Tuesday against a backdrop of historic upheaval in the U.S. financial system.
Lehman Brothers Holdings Inc. (LEH, Fortune 500), the country's fourth-largest investment firm, filed for bankruptcy protection on Monday. And, Bank of America (BAC, Fortune 500) is buying Merrill Lynch (MER, Fortune 500) in a $50 billion deal.
"It puts a Fed rate cut back on the table," said Stuart Hoffman, chief economist at PNC Financial Services Group.
Seeking to calm frazzled markets, President Bush assured the country his administration is "working to reduce disruptions and minimize the impact of these developments on the broader economy."
The Dow Jones industrial average plunged more than 200 points in morning trading.
During emergency sessions over the weekend, Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson made clear there would be no government bailout of Lehman. The Fed took steps Sunday night to keep cash flowing to major Wall Street players by expanding its loan programs, however.
Before the extraordinary events over the weekend, the prevailing wisdom was that the Fed would hold its key interest rate steady at 2% at its next meeting on Tuesday.
Although that still could happen, a growing number of economists and investors now believes there is a chance the Fed could reduce its rate by one-quarter or even a bolder one-half percentage point on Tuesday. Much hinges on the information the Fed gets about how the inner workings of the U.S. financial system are functioning and how Wall Street investors react to the crisis.
"It is a different ballgame. Anything can be expected and a rate cut is possible," said economist Richard Yamarone, economist at Argus Research. Yamarone thinks the Fed on Tuesday will decide to stay the course and leave rates alone, fearing another cut would hurt the value of the U.S. dollar more. Hoffman, too, isn't convinced a rate cut will happen.
Were the Fed to slice its key rate, the prime lending rate for millions of consumers and businesses - now at 5% - would drop by a corresponding amount. The prime rate applies to certain credit cards, home equity lines of credit and other loans. The Fed's key rate and the prime rate are at four-year lows.
Even if the Fed doesn't lower rates on Tuesday, analysts believe the central bank could switch signals and suggest it could cut rates sooner down the road.
Over the last few months, Bernanke and his Fed colleagues have signaled that the central bank's next move on interest rates would probably be an increase to fend off inflation.
A recent retreat in record-high oil prices and improved readings on wholesale prices, however, gives the Fed more leeway to lower rates if needed or at least hold them steady.
The Fed in June halted its most aggressive rate-cutting campaign to shore up the economy out of fears that those low rates were aggravating inflation. It didn't budge the rate at the last meeting in August for the same reason.
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