Wall Street to Fed: Cut rates now!

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NEW YORK (CNNMoney.com) -- A nearly $10 billion loss from Citigroup. Weak retail sales last month. Rising inflation pressures. It's ugly out there.

With all that in mind, investors are now betting the Federal Reserve may cut interest rates before its next scheduled meeting, a two-day session that wraps up on Jan. 30.

Some economists have argued that the United States is close to a recession or may already be in one.

"Fundamentally, we're on the verge of a recession. The economy may pull back from the cliff but I wouldn't count on it," said David Wyss, chief economist with Standard & Poor's.

Federal Reserve chairman Ben Bernanke said last week that he did not think the economy would slip into recession. But he acknowledged that the economic outlook for 2008 "has worsened and the downside risks to growth have become more pronounced."

The market now thinks it is a lock the Fed will cut its key federal funds rate by at least half of a percentage point, or 50 basis points, to 3.75 percent by the end of the month, according to futures listed on the Chicago Board of Trade.

What's more, the futures are pricing in a 44 percent chance of a 75 basis point cut. Because such a move at one meeting would be considered extremely aggressive, some analysts think the Fed will act even before Jan. 30.

"Let's face it. The stock market and investor confidence is being taken into consideration by the Fed," said Ashraf Laidi, chief currency analyst with CMC Markets U.S., a New York-based brokerage firm.

"All the dismal data cement a half-point cut. But things have gotten so bad that just a 50 basis point cut would trigger a disappointing reaction," Laidi added.

Bernanke is set to testify in front of the House Budget Committee Thursday morning in a hearing about the near-term outlook for the economy.

Laidi said he would not be surprised if the Fed moved to cut rates after this hearing, especially if reports on Wednesday on consumer prices and industrial production confirm economic weakness and contained inflation.

Laidi compared the possibility of an inter-meeting cut now to the emergency rate cut in January 2001 by Bernanke's predecessor Alan Greenspan. That was right before the last recession began.

But Wyss isn't as sure that the Fed would follow Greenspan's example.

For one thing, the 2001 rate cut took place on Jan. 3, four weeks before a scheduled meeting. This time around, a Fed meeting is roughly two weeks away.

The Fed has already cut the federal funds rate - an overnight bank lending rate that affects how much interest consumers pay on credit card debt, home equity lines of credit and many other loans - from 5.25 percent to 4.25 percent since September.

The central bank has also reduced the discount rate, which is what it costs banks to borrow directly from the Fed, from 6.25 percent to 4.75 percent since August.

Investors have been arguing for more, and bigger, rate cuts in the hopes that it will kick start a moribund economy and encourage businesses and consumers to spend.

Still, others think the Fed needs to proceed cautiously, especially since it's fair to argue that aggressive rate cuts during 2001 may be the reason why banks are in the subprime mortgage mess they are in now.

In addition, the Producer Price Index, released Tuesday could keep the Fed on guard. Although overall wholesale prices fell slightly in December, they were up 6.3 percent in 2007. The high prices of oil, gold and other commodities, combined with a weak dollar, are also an indication that pricing pressures haven't disappeared.

"Inflation is alive and well," said Laidi.

What's more, Steve Van Order, chief fixed income strategist with Calvert Funds, a Bethesda, Md.-based investment firm with $15 billion in assets under management, said that there are signs that credit-market conditions are already getting better.

The Fed has conducted three auctions in conjunction with other central banks around the globe to loan a combined $70 billion to banks facing a cash crunch. The Fed announced the results of the third auction, for $30 billion, on Tuesday.

"We're not out of the woods out of yet but the financial markets are stabilizing and are in better shape. The auctions have helped there," Van Order said.

Van Order added that even though Citigroup's massive loss and $18.1 billion writedown of bad mortgage investments is a troubling sign, it is somewhat encouraging that Citigroup (C, Fortune 500) did not wind up confirming some of the worst-case scenarios on Wall Street. There had been speculation that the writedown would be upwards of $25 billion.

So Van Order thinks it's finally time for the Bernanke-led Fed to stand up to the markets and show Wall Street that it is calling the shots and will reduce rates at the pace it thinks is reasonable.

"The market is trying to test the Fed, lead it and push it to deeper rate cuts," he said. "The Fed probably need to eventually lower interest rates to 3 percent but I don't know if they want to go to 3.5 percent in one fell swoop."