Washington — For the first time in more than four years, the Federal Reserve appears ready to lower interest rates to prevent a housing meltdown and a painful credit crunch from driving the economy into a recession.
A rate cut would affect millions of borrowers, with the intention of getting them to spend and invest more, which would revitalize the economy.
In one of their most important and anxiously awaited decisions, Fed Chairman Ben Bernanke and his central bank colleagues meet Tuesday to determine their next move on interest rates. Those policymakers are widely expected to cut an important rate, now at 5.25 percent, by at least one-quarter of percentage point. Some analysts predict a bolder step, a half-point reduction.
If the Fed drops the rate, then the prime lending rate that commercial banks charge many individuals and businesses would fall by a corresponding amount. It now is at 8.25 percent.
"It's no longer a debate over whether they will ease but by how much," said Mark Zandi, chief economist at Moody's Economy.com. "The economy is soft and getting softer," and the Fed has come under economic and political pressure to act.
Should the Fed go with a quarter-point cut, analysts expect policymakers will lower the rate again in October and in December, their final meeting of the year.
Fed action would mean that borrowers who can obtain credit would see rates drop on a variety of loans. It would become less expensive for people to finance certain credit card debt and for homeowners to take out popular home equity lines of credit, which often are used to pay for education, home improvements or medical bills.
Also, it should help some homeowners whose adjustable-rate mortgages reset in the fall.
"Borrowers facing a rate reset Oct. 1 might see their ARM rates adjust to 6.7 percent, for example, rather than the 7.5 percent that a borrower whose loan adjusted back on July 1 experienced," said Greg McBride, senior financial analyst for Bankrate.com. "Still a big increase, but not the knockout punch it could have been," he said.
'Like taking an antibiotic'
Less immediate would be relief for the country's economic health. An expected series of rate decreases could take three months to nine month before rippling through the economy and bolstering activity.
"It's like taking an antibiotic. After you take the first dose, you don't feel immediately better. But after a series of dosages accumulate, there will be a more positive effect," explained Stuart Hoffman, chief economist at PNC Financial Services Group.
Over the short term, a rate cut would provide an important psychological boost. It could make investors, businesses and others less inclined to clamp down or make drastic changes in their behavior that would hurt the economy.
Fears that the deepening housing slump and a spreading credit crisis could short-circuit the six-year-old economic expansion have shaken Wall Street over the past few months. Stocks have swung wildly, with sharp drops reflecting investors' bouts of panic.
A recent government report showing that the economy lost jobs for the first time in four years delivered a fresh jolt. The biggest fear is that individuals and businesses will cut back on spending, throwing the economy into a tailspin.
By Zandi's odds, there now is a 40 percent chance the economy will fall into a recession - the highest probability since the last recession, in 2001. Just two months earlier, Zandi believed there was only a 12 percent chance.
So far, though, consumers have not cracked. Retail sales rose a modest 0.3 percent in August, after a 0.5 percent gain in July, the government reported Friday.
Housing and employment
Problems have been most pronounced in housing.
But, Fed Governor Frederic Mishkin said recently, "economic activity could be affected more severely in other sectors should heightened uncertainty lead to a broader pullback in household and businesses spending."
He added, "That scenario cannot, in my view, be ruled out, and I believe it poses an important downside risk to economic activity."
Analysts expect the economy will slow to a rate of about 2 percent in the current quarter, from July through September. That would be just half the rate of the three previous months. Growth in the final three months of this year could turn out even weaker.
The employment climate is starting to deteriorate. Employers eliminated 4,000 jobs in August, intensifying calls by politicians and others for the Fed to cut rates. The unemployment rate, now at 4.6 percent, is expected to climb close to 5 percent by the year's end.
The weakness in employment was troubling because job and wage growth have served as shock absorbers for people coping with the housing slump.
After a five-year boom, the housing market went bust more than a year ago. Higher interest rates and weaker home values clobbered homeowners, particularly "subprime" borrowers with spotty credit histories or low incomes. Foreclosures set records and late payments spiked. Lenders were forced out of business. Hedge funds and other investors in subprime-related mortgage securities took a huge financial hit.
A credit crisis ensued, spreading beyond the subprime market to more creditworthy borrowers.
"If current conditions persist in mortgage markets, the demand for homes could weaken further, with possible implications for the broader economy," Fed Governor Randall Kroszner said in a recent speech.
Former Federal Reserve Chairman Alan Greenspan, in an interview broadcast Sunday on CBS' "60 Minutes," said he believes the economy will be able to weather the financial storm.
"For the moment it does not look sufficiently severe that it will spiral into anything deeper," he said. "We're going to get through this particular credit crunch. We always do. This is a human behavior phenomenon, and it will pass. The fever will break and euphoria will start to come back again."