Turmoil may goad Fed into a rate cut on Tuesday

The Fed has held the interbank overnight interest rates steady at a low 2 percent since April to help the economy recover from a deep housing market decline and sharp lending pullback.

"The Fed appears more willing to address the current credit and economic difficulties through an expanded discount window and credit facilities rather than a cut in interest rates," John Silvia, chief economist for Wachovia Economics Group in Charlotte, North Carolina told Reuters.

The U.S. central bank will announce its decision on interest rates at around 2:15 p.m. EDT.

According to the Credit Suisse index on interest rates pricing, there is a three-in-four chance the Fed will cut the benchmark fed funds rate to 1.75 percent from 2 percent in order to spur the U.S. economy struggling under credit market turmoil.

Policy-makers said at their most recent meeting in early August that the Fed would act as needed if economic and financial developments posed a threat to sustainable economic growth and stable prices.

On Monday, U.S. stocks plummeted with the Dow Jones industrial average posting a more than 500-point drop, its biggest one-day slide since September 2001.

The tumble in stocks followed a whirlwind weekend that saw the bankruptcy of 158-year-old Lehman Brothers Holdings, the sale of investment bank Merrill Lynch to Bank of America, and a scramble for more cash by insurer American International Group.

Yet the severity of recent problems has led many to call for the Fed to go back to the most powerful weapon in its arsenal, rate cuts. Fed rate futures put chances of a rate cut as high as 92 percent, but settled to 72 percent on Monday.

Even so, many observers believe the Fed, which worried in August that inflation was high and that indicators of inflation expectations were elevated, will hold fire on rate cuts on Tuesday.

"To act now could interfere, slow or distract the private sector from undertaking the necessary steps to work out their problems on their own," wrote Bernard Baumohl, an economist with the Economic Outlook Group in Princeton, New Jersey.

In making any shift that would open the door to rate cuts, the Fed could cite a weakening economy and a more benign outlook for inflation. The labor market picture remains steadily dismal, with eight consecutive months of job losses and the highest unemployment rate in five years in August.