Wall Street jittery before the Fed

NEW YORK (CNNMoney.com) -- Stocks slipped Monday afternoon as investors worried that Federal Reserve policy makers won't cut a key short-term interest rate by as much as has been hoped when they meet to discuss policy on Tuesday.

The Dow Jones industrial average (down 42.03 to 13,400.49, Charts) lost 0.3 percent 3 hours into the session. The broader S&P 500 (down 8.07 to 1,476.18, Charts) index lost 0.5 percent and the tech-heavy Nasdaq composite (down 21.18 to 2,581.00, Charts) declined around 0.8 percent.

Stocks ended barely higher Friday, at the end of an upbeat week influenced by hopes that the Federal Reserve will cut interest rates Tuesday for the first time in over a year.

But the tone Monday was more tentative, as investors worried that the Fed might not cut a key short-term interest rate by as much as had been hoped.

"I think there's a realization this week that there really is no free lunch," said John Merrill, chief investment officer at Tanglewood Capital Partners.

Merrill said that last week, stocks rose because investors were focusing on how a rate cut will help the economy. But this week, there's a bit more of a reality check, he said, partly because former Fed chairman Alan Greenspan has been talking a lot over the last few days, due to the release of his new book.

"I think there's more of a recognition that the Fed is in a tight spot, particularly with Greenspan raising the reality that even if the Fed cuts rates, it's going to potentially drive up inflationary pressures," Merrill said.

The fed funds rate has stood at 5.25 percent since June 2006, with the central bank seeking to balance inflationary pressure with the risks of an economic slowdown sparked by the housing market collapse.

The recent rise in mortgage defaults and the tightening of credit have raised bets on Wall Street that the central bank will have to cut interest rates. The Fed has already cut the discount rate, which affects bank loans, and pumped billions into the banking system in temporary overnight reserves, so as to keep liquidity flowing.

Wall Streeters are now looking for the Fed to cut the fed funds rate, which impacts consumer loans, with the current debate about the extent of the cut.

Many Wall Streeters are looking for a half-percentage point cut Tuesday. However, the central bank could decide to cut by a quarter-percentage point instead. There is also the possibility that the Fed will not cut the fed funds rate at all.

Ahead of the Fed announcement, investors eyed Monday's one economic report of note, the NY Empire State index, a regional manufacturing report. The index fell to 14.7 in September from 25.1 last month, missing forecasts for a smaller drop to 18, according to Briefing.com estimates.

Also impacting early trade: comments from former Fed chairman Alan Greenspan about the current financial market turmoil. Greenspan reportedly told news outlets that a risk of recession is greater now than it was at the beginning of the year.

In an interview with Fortune, Greenspan also said that the subprime mess was an "accident waiting to happen," and that the Fed is in a tricky situation now where they can't just cut rates anymore without risking boosting inflation. (For more details, click here.)

In corporate news, Microsoft (down $0.35 to $28.69, Charts, Fortune 500) suffered a big setback when a European Union court dismissed the company's appeal of a 2004 antitrust ruling. (For details, click here.)

Ahead of their earnings reports, a variety of banks slumped, including Lehman Brothers (down $0.64 to $58.86, Charts, Fortune 500), Morgan Stanley (down $1.48 to $64.63, Charts, Fortune 500), Goldman Sachs (down $2.61 to $187.98, Charts, Fortune 500) and Bear Stearns (down $2.35 to $114.84, Charts, Fortune 500). The Amex Securities Broker/Dealer index fell by 1 percent.

Brokers have been among the hardest hit sectors in the financial market meltdown, and investors will be paying close attention to see what the companies have to say about the fallout. (For details, click here.)

Reminding investors of the global reach of the mortgage crisis was Northern Rock, one of Britain's largest mortgage lenders. Northern Rock slumped 30 percent in European trading as nervous investors withdrew billions, AP reported. On Friday, the stock slumped more than 30 percent as well after the company admitted it had received emergency funding from the Bank of England.

Stock gainers included InfoSpace (up $3.61 to $16.86, Charts), which jumped 27 percent on news that it will sell its online directory business to privately-owned Idearc for $225 million.

Market breadth was negative. On the New York Stock Exchange, losers topped winners by almost three to one on volume of 540 million shares. On the Nasdaq, decliners topped advancers five to two on volume of 750 million shares.

Treasury prices fell, lifting the yield on the 10-year note to 4.47 percent from 4.46 percent late Friday. Bond prices and yields move in opposite directions.

U.S. light crude oil for October delivery rose 90 cents to $80 a barrel on the New York Mercantile Exchange, not far from a record closing high hit late last week.

COMEX gold for December delivery rose $6.40 to $724.20 an ounce.