Even as short-term rates have fallen in the U.S., a widely used lending benchmark called the London Interbank Overnight Rate, or Libor, has risen. That’s a sign that banks and investors are afraid of further credit fallout, so they’re demanding higher rates from borrowers to compensate for that risk.

A cut by the U.S. central bank could help calm those lenders and investors and restore flows of cash to some forms of borrowing that have dried up since the credit squeeze began in early August.

“Financial conditions are tighter today than they were a month or two ago,” said Jay Bryson, global economist at Wachovia. “In order to offset that the Fed needs to be easing to try to bring some of those rates down.”

But a move to cut rates is not without risks. The recent turmoil in the credit markets is due in part to a period of easy money policy after the dot-com bubble burst — when the Fed, under the leadership of former Chairman Alan Greenspan, cut the benchmark overnight rate to as low as 1 percent. That policy helped fuel the lending spree that pumped U.S. housing prices to unsustainable levels. Now that the excesses of the housing boom have been reined in, the Fed is loath to begin another round of cheap credit.

The Fed has also long maintained that its primary goal is to fight inflation. On that front, it’s shown good progress: A key inflation indicator the Fed watches closely has recently fallen below the central bank’s perceived target of 2 percent annual price growth.

But loosening credit now could set the stage for higher inflation down the road. Strong demand for crops used for both food and biofuels have driven up food prices. Crude oil recently topped $80 a barrel. A strong global economy has tightened supplies of others commodities like steel and other building materials.

“Longer term, if the Fed is sowing the seeds of an inflation problem and the economy turns out not to be this weak, there could be a price to pay for this long-term,” said Michael Darda, chief economist at MKM Partners.

Assessing the health of the economy is probably the Fed’s toughest task at the moment. Its own survey of economic conditions at the 12 regional member banks last month found that while the pace of economic growth is slowing, business conditions are still relatively healthy. Recent data on industrial production seem to confirm that view.

But last month’s weak employment report — showing a net loss of 4,000 jobs in August — came as a surprise to economists and analysts who had been looking for gains of over 100,000 new jobs. The report also said job growth was weaker than initially reported in June and July.

The rising pace of home foreclosures and the slowdown in mortgage lending also poses a threat to future growth — and raises the possibility that the recession now gripping the housing market spills over to the broader economy. Though such a full-blown recession isn’t inevitable, say many economists, the odds of one occurring have risen as the housing and mortgage markets have fallen.

Former Fed governor Lyle Gramley notes that since World War II, every downturn in housing has been followed by a recession – with the exception of housing slumps in 1950 and 1966 “when we had big increases in defense spending that kept the wolf at bay,” he said.

While some FOMC members may want to cut rates more quickly — by a half percentage point — Fed watchers note that it will be easier to reach a consensus for a quarter point cut. But Bryon is in the camp who thinks that recent signs of economic weakness indicate that a more aggressive cut is needed.

“If over the next few months we find out that (economic) growth is really stronger than we think, and the economy didn’t really need the (half point) cut, they can reverse it and they can reverse it pretty quickly,” he said. “But I think that downside risks to growth are starting to build at this point.”

 

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