Fed expected to leave interest rates as is

WASHINGTON -- The Federal Reserve is expected to sit tight on interest rates when it meets on Tuesday, despite mounting evidence that the economy is rapidly slowing and inflation has begun to moderate.

Several economists caution that the central bank might have to cut a key rate later this year to boost activity if the job market, consumer spending and banking conditions keep deteriorating.

"We would expect (the Fed) to hold pat, but there's clearly a growing possibility that some time in the next couple of months, they may have to cut," says Nigel Gault, chief U.S. economist at Global Insight. "It's a combination of things — the economy slowing and the continuing financial crisis. … For the markets, (a cut) lowers the cost of funds."

After slashing rates to fight the fallout from the housing market meltdown and financial market turmoil, the Fed has held its target for a key interest rate steady at 2% since April 30.

Dallas Fed President Richard Fisher has voted against that policy, saying rates are too low, given inflation pressures. Banks use the federal funds rate, what banks charge each other for overnight loans, as a guide in pricing consumer and business loans.

The consumer price index jumped 5.6% in the 12 months ended in June, the biggest year-over-year rise since 1991. But there are signs that inflation could be abating. The Labor Department on Friday said the wholesale inflation rate fell in August. Crude oil prices have fallen from a high of $145 this summer to near $100 on Friday. In a recent speech, Fed Chairman Ben Bernanke said lower energy prices, if sustained, could mute inflation pressures.

At the same time, the economy is slowing. Bernard Baumohl, managing director of the Economic Outlook Group, notes that one-time federal tax rebates have now been spent, giving less support to consumers going forward. Unemployment is the highest in five years, home values are falling, employee pay is lagging behind inflation by the biggest margin in 17 years, and global growth is slowing.

"The U.S. economy is devoid of any forward momentum," Baumohl says, adding the Fed is likely to cut rates later if the economy keeps declining.

Further rate reductions might be of minimal help unless banks become more willing to lend, and could depress the value of the U.S. dollar or spark new price pressures. Inflation is still far higher than the Fed wants. Brown Bros. Harriman notes that the recent increase in the dollar appears vulnerable to market expectations about rate cuts.