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Rate-Cut Odds Lengthen

All eyes now turn to jobs data looming later this week.

The latest report from the

Federal Reserve

shows that a Sept. 18 fed funds rate cut is far from a sure thing.

The Fed's beige book report -- an update on the state of the U.S. economy by geographic district, from July 17 through Aug. 27 -- said most regions were still reporting economic expansion, even as Wall Street was enduring a credit crunch that has many observers warning that a recession could be just around the corner.

In the wake of Wednesday's beige book data, that camp -- people who want to see the Fed juice the economy by trimming interest rates -- will start to look to Thursday's employment data for support for their case. Economists say signs that unemployment is on the rise could spur the Fed to act.

Until jobless claims start rising substantially, though, the rate-cut case seems decidedly weak.

"The headlines fail to make a clear case for the Fed to ease," writes T.J. Marta, fixed income strategist at RBC Capital Markets.

The comments from dstricts around the country weighed on stock investors, who have been banking on a cut in the fed funds rate that governs overnight bank loans. The

Dow Jones Industrial Average

, which had been lower all day on a dismal July pending home sales report, fell further after the beige book came out. The Dow showed a 192-point decline at 2:30 p.m. EST, just half an hour after the report's release. Stocks rebounded somewhat before the close, with the Dow finishing down 143 points on the day.

The report comes less than a week after Fed Chairman Ben Bernanke signaled in a speech that the central bank's policy-setting arm is closely watching the timeliest economic indicators to make sure the economy isn't headed for a fall.

But investors fear that by standing pat on the fed funds rate, the Federal Reserve could cause a recession. Some believe that the Fed, by keeping the funds rate at 5.25%, risks allowing a credit crunch that has weighed on the financial sector to spread into the real economy.

The credit crunch has already wrought havoc on mortgage industry players such as

Thornburg

(TMA)

and

Countrywide

(CFC)

and on big brokers such as

Bear Stearns

TheStreet Recommends

(BSC)

and

Lehman Brothers

(BSC)

.

So far, though, the Fed is signaling that it sees little evidence for those fears.

"Outside of real estate, reports that the turmoil in the financial markets had affected economic activity during the survey period were limited," read the beige book.

In the beige book, banks reported tighter lending standards in the residential mortgage space throughout late July and August, as housing sales and prices continue to move lower. But credit availability and credit quality for consumers and businesses remained good, according to the report.

There was no indication that consumers or businesses with strong credit histories are having problems accessing capital. Likewise, the report noted that the commercial real estate market remains intact.

Marta notes that "weaker activity in four districts would be a key support to cut the fed funds rate," but that didn't come.

This leaves the markets looking to Thursday's initial jobless claims and Friday's August unemployment report to seal the deal on a rate cut. Economists say the Fed needs to see a meaningful increase in unemployment to justify a rate cut. As it stands, the unemployment rate is at 4.6%. The consensus of analysts predict another 4.6% unemployment reading and 110,000 new jobs added in August.

The report noted that "nearly every district reported at least modest increases in employment during the recent survey period." Some still described the labor market as "tight." Wage increases were "moderate or steady," with most districts reporting no great price pressures. Some regions reported higher food and restaurant prices.

In the service sector, regions reported "strong gains" in financial, health care, technology, technical and professional services, which fits with Wednesday's ADP National Employment report, which reflected job growth in the service sector and job losses in the goods-producing sector. The ADP report said the economy added just 38,000 new jobs, exluding government jobs, in the month of August.

Manufacturing activity expanded in most areas, but there was softer demand for the already weak areas of the economy -- building materials and autos, according to the Fed report.

"There's a lag time," says Mike Malone, trading analyst at Cowen & Co. "It could be months before the economy shows the effects of the credit market crisis of confidence." Malone believes the Fed will cut the overnight borrowing rate to pre-empt further economic deterioration.

"It may not be until November before people either say, 'The effects should have shown up by now, or they're not going to show up,'" says James Paulsen, chief investment strategist at Wells Capital Management.

Paulsen, however, thinks that if the data remain strong enough, the Fed will hold out on cutting rates. He believes the Fed should keep rates steady till an easing would have a substantial impact on the markets. Right now, he points out, investors expect a cut -- and stocks are on the rebound anyway, Wednesday's action notwithstanding.The Dow is now just within 5% of July's 14,000 all-time high.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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