Financial markets are pushing the Federal Reserve hard to make deep cuts in its federal funds target. Fed funds futures show only a mild expectation for a rate cut at month-end but do show a 25-basis-point move by year end and another 25 point move by the end of the first quarter. Former Federal Reserve Chairman Alan Greenspan has emerged as the most forceful spokesman for lower rates, using the global press to warn that the risk of recession has risen sharply. He's not making the job for his former colleagues at the Fed any easier. Those actually involved in the decision are keeping their options open, underscored last week by St. Louis Fed President William Poole who warned that nothing has been chiseled into stone and that it may not be so smart after all for the markets to have priced in rate cuts.

Whether the turn lower in the funds rate proves deep or proves shallow will depend on the play between economic growth and inflation. If growth, despite the credit-market squeeze, remains steady, the Fed will be able to keep up its guard against inflation. If economic growth fizzles, the Fed will be forced to turn their attention away from inflation and give the markets what they want.

The graph above compares annual GDP growth against the funds target. Looking at the two main downward slopes in the funds rate, the first in the early 90s and the second in the early 00s, shows that growth snaps back toward the bottom of each slope, jumping from slightly negative ground in '91 to about 3 percent (position '1' in graph) and rising from about 1 percent in '01 to about 2-1/2 percent by '03 (position '2'). The two smaller downward slopes in the funds rate, in '95 and '98, are also followed by gains in GDP (positions '3' and '4'). A similar jump in GDP at the end of this year or the beginning of next, results which are possible but not expected, would definitely limit any further rate cuts.

Now let's turn to the funds target compared with the most prominent measure of inflation, the year-on-year rate for the overall CPI. Lower rates in '91 didn't trigger much inflation as the CPI actually slowed from above 6 percent to a stable 3 percent. Soft GDP at that time was definitely a factor behind the lack of inflation pressure. The small downward slope in the funds rate in '95 was followed by an uptick in the CPI with the second downward slope in the funds rate also followed by an increase. What's interesting about the upward slope in the funds rate beginning in '04 is that it seems to lag the steady increases already underway in the rate of inflation, suggesting that inflation, spiking at 15-year high in '05, was a bit out in front of the Greenspan Fed. But by '06, with funds on a 5-1/4 percent plateau, the CPI came back down, now in safe ground near 2 percent. Had inflation not backed down this year -- credit crunch or no credit crunch -- there wouldn't have been any rate cut, small or jumbo, on Sept. 18.

Let's finish up with a quick look at some key indexes and indicators to watch in the beginning of the new rate regime. The graph above compares the funds target with the year-over-year change in the Dow industrials over the past eight years. Note that rates of growth in the Dow peaked, at nearly 35 percent, when the funds rate was at its lowest in '03. Also note that rates of growth in the Dow are currently high even as the Fed begins to cut rates.

The Fed will be keeping a special watch on the unemployment rate to see if available resources including the labor pool, are being overly pressured. The unemployment rate in the graph above is inverted, meaning gains in the black line indicate rising demand for labor. Employment perked up in '03 and was later followed by rate hikes beginning in '04. New increases in employment, that is a lower unemployment rate, would seriously raise inflation worries at the Fed and would very likely limit, if not cut short, further rate cuts. A look below at a graph of year-over-year percent growth for average hourly earnings shows that earnings growth, though elevated, is slowing. Slower earnings are good for inflation but may limit growth in retail sales.

Changes in retail sales will be pivotal for the Fed. The graph below shows that year-over-year rates of growth in retail sales peaked in '05 at a very strong 9 percent. Rates have eased back to a moderate trend near 4 percent. Growth much below the current level would be unacceptable and would raise expectations for further and deeper rate cuts.

We'll wind up with a look at the most shaky sector right now, the housing sector of course. What's striking about the graph below is the enormous range in which housing starts move. The year-over-year percent change on the right scale is +50/-50 percent! The severity of recent declines, at nearly 40 percent at the beginning of the year, has eased substantially though they are still at an eye-popping 20 percent. Even modest improvement in the housing sector, especially now against softer comparisons following two years of downturn, could make for quick improvement in percentage changes and in turn make for positive headlines, for once, on the housing sector.

Bottom line

Whether expectations call for another rate hike at month end will hinge heavily on Friday's employment report. The unemployment rate is expected to rise a tenth to 4.7 percent which, provided that payroll change is likewise soft, could easily raise expectations for a 25-basis-point cut. A solid report would firm expectations for no change while a very strong report, with a surprise downtick in the unemployment rate to 4.5 percent for instance, would jolt all assumptions, pointing to a shallow dip this cycle for the funds rate.