Will the US Federal Reserve cut interest rates on Tuesday 11 December? And what about after? Wall Street economists firmly expect a rate cut of a quarter per cent and a larger reduction in the discount rate when the Federal Reserve meets on Tuesday to consider its monetary policy. Some analysts still feel a surprise half-point reduction in the inter-bank rate is not out of the question.

The Fed is likely to cut the federal funds target rate by 25 basis points from 4.5 per cent to 4.25 per cent, and the discount rate the Fed charges for direct loans to banks by 50 basis points, from 5 per cent to 4.5 per cent. The Fed is also expected to create room for further cuts if necessary by characterising the risks as tilted towards a further economic slowdown.

Sub-prime pain
Very little has gone right for the central bank since the last FOMC meeting on 31 October, when the Fed announced a 25 basis point cut, but said the markets should not assume there will be more to come. Economists had hoped that the financial markets would gradually improve after remaining calm through October. But what they got instead was new storms.

Since 31 October, megabanks like Citigroup, Bank of America, and HSBC have announced billions of dollars worth of write-downs owing to exposures to sub-prime mortgages. As financial market fears have spread over the actual extent of sub-prime problems, credit availability has stiffened, fuelling more worries at the Fed.

Priced in
A quarter per cent cut would therefore be a sort of middle ground between the FOMC's neutral policy stance at its last meeting on 31 October - where it said that interest rate cuts might end - and market expectations which, until the positive jobs report, saw a good chance of a half-point cut in the federal funds rate.

Futures on the Chicago Board of Trade have priced in a 100 per cent chance the Fed will lower its target for the overnight lending rate between banks by at least a quarter-per cent to 4.25 per cent, the third cut since September. They also forecast a 50 per cent chance that the Fed will cut rates again at its next two meetings, on 30 January and 18 March.

Inflation imperative
But will the 2008 cuts really come about? Fed Chairman Ben Bernanke may have less room to lower borrowing costs in future than investors anticipate. The expected inflation rate reached 2.91 per cent last week, the highest since 2004, when the central bank began the first of an unprecedented 17 rate increases. The inflation rate was at 2.79 per cent on 1 November.

The Fed emphasises measures to keep longer-term inflation within expectations. This means it is willing to tolerate short-run inflationary movements, but only to the extent that they don't derail long-term inflation expectations. Any evidence that accelerating inflation is becoming entrenched will make the Fed balance the pros and cons of cutting rates.

On the one hand is a situation where the worst housing market in 16 years and mounting losses in securities related to sub-prime mortgages are threatening to tip the economy into recession.

On the other, the five-year forward breakeven inflation rate suggests that bets on lower Fed funds rates may be too bold. A cooling economy typically tempers inflation concerns. When the market keeps the same inflation expectations while lowering growth expectations, it means there are inflationary pressures.

TIPping the scales
Analysts derive the measure of inflation expectations from yields on five- and 10-year Treasury Inflation Protected Securities and Treasuries (TIPS). Five-year TIPS yield 2.17 per cent less than five-year notes. This is the average inflation rate investors expect over the next five years. This forward rate projects what the breakeven will be in five years, smoothing short-term surges or dips in inflation from swings in oil prices or other events.

The five-year TIPS breakeven rate rose to a six-month high of 2.47 per cent on 27 November, a week after oil climbed to a record $99.29 a barrel, from about 1.9 per cent on 31 August. And when crude fell to a six-week low on 6 December the breakeven rate declined the following day.

Dollar in the doldrums
The dollar, likely to continue depreciating against the euro for a second straight year, is also fuelling inflation concerns. The currency's drop and oil's advance pushed import prices up 1.8 per cent in October, the most in 17 months. Consumer prices increased 4.1 per cent last month, up from this year's low of 2 per cent in August and the biggest rise since July 2006. Food, imports and energy prices may also raise inflation expectations, Bernanke said in a 30 November speech in Charlotte, North Carolina.

Inflation is one of the reasons the market is expecting a 25 basis-point cut, rather than 50 basis points as, for the present, growth takes priority. But investors seeking a haven from sub-prime related losses tend to look past signs of inflation.

Treasury bonds have already priced in a 50 per cent possibility of a further one per cent cut in the Fed funds rate. Some analysts seem to think that the Fed may drop its target below 3 per cent to support growth.

Credit crunch
But the key for the central bank's Tuesday meeting is the unsettled conditions in financial markets, which are in some measures worse over the past six weeks than when the turmoil started in July and August. Commercial banks seem to have stopped lending to each other in order to protect their capital.

Interbank lending rates soared to nine-year peaks at the start of this month, as banks rushed to secure cash for the new year. At the same time, interest rates on US Treasury bills slipped to August lows last week as investors sought safe money havens.

So far, outside of the housing and financial services sectors, the US economy has exhibited remarkable resilience. Many retailers have reported stronger-than-expected November sales and a slumping dollar has helped boost demand for US exports.

The risk of a flare-up in inflation appears to be somewhat subdued at present, not counting volatile energy and food costs. But how the Fed will move in future has much to do with inflation. Unless, of course, the sub-prime crisis continues to inflict more and more pain on banks and financial institutions in the first half of 2008.

Heightened financial market uncertainty opens the door for an inflation-wary Fed to acknowledge that risks are now tilted toward a stumble in growth. It invites a half-point cut in the interbank federal funds rate. But odds are that policy-makers will opt to trim that rate by just a quarter point, and try to unlock credit flows by offering a larger cut in the discount rate.