A surprising drop in payrolls in July may have opened the door to aggressive interest-rate cutting by the Federal Reserve just a day after central bank officials said the economy appeared healthy outside of weakness in the housing market.

If there was any doubt over whether the Fed would be cutting interest rates on September 18, this report should remove it, said Nigel Gault, an economist for Global Insight in Lexington, Massachusetts, referring to the central bank's upcoming policy-setting meeting on September 18.

Fed officials, who in speeches on Thursday stressed there was no conclusive evidence that problems in housing and credit markets had spilled over to the broader economy, may have gotten a wake-up call from a U.S. Labor Department report showing the economy shed a net 4,000 non-farm jobs in August.

It was the first decline in employment since August 2003.

RENEWED URGENCY

While central bank policy-makers earlier this week had played down the chances of quick interest rate cut and suggested any Fed response to market volatility would be deliberate and measured, the unexpectedly bleak employment report added a note of urgency to the mix.

Contributing to signs the economy may be cooling more quickly than officials had anticipated, revisions to the jobs data showed employers added 81,000 fewer jobs in July and June than previously reported.

The question is now whether the Fed should be more aggressive and cut by 50 basis points on September 18, Gault said.

U.S. short-term interest rate futures boosted the implied chances of a half-percentage point cut in the benchmark federal funds rate to 72 percent from 42 percent before the jobs report was published on Friday, and economists said a series of interest rate reductions might be in store.

The Fed's rate-setting Federal Open Market Committee has held the federal funds rate target steady at 5.25 percent since June of last year.

The Fed's Beige Book, an anecdotal snapshot of economic conditions, released by the Fed on Wednesday had said that outside of the housing sector, recent credit market problems had not appeared to have hit the economy.

The jobs report, however, raised the troubling prospect that businesses may be putting off new hires just as tighter credit conditions and a prolonged housing slump start to weigh on consumer enthusiasm.

Chatter about the FOMC being behind the curve will pick up significantly in the coming months and cries for deep cuts in the fed funds rate will be loud, said Chris Jarvis, an analyst with Caprock Risk Management.

Many observers said Fed Chairman Ben Bernanke bought time to assess his options before any interest rate cuts with a speech last week in which he acknowledged the global recent liquidity and credit squeeze could threaten economic growth. The Fed would act as needed to prevent that from happening, he said.

REMOVES MORAL HAZARD STIGMA

Bernanke also warned it was not the Fed's role to rescue investors who underestimated the risks of some assets and have lost money as a result, a point underscored by other Fed officials who spoke this week.

The U.S. jobs report though may provide the Fed with evidence the economy is on a shaky path and outweigh concerns a rate cut would give investors the impression the central bank will rescue them in times of stress, leading to undue risk taking, a dynamic referred to as moral hazard.

This reinforces (the Fed) acting because of downside economic risks, not because of bailing out Wall Street, said Stuart Hoffman, the chief economist for PNC Financial Services Group in Pittsburgh. This really takes away the stigma of any sort of moral hazard if the Fed eases in September.

In his speech a week ago, Bernanke acknowledged increased uncertainty about the economic outlook and said policy-makers would watch data carefully for warning signs.

The payrolls report suggests that evidence of economic weakness is now too severe to dismiss, said Stephen Stanley, chief economist for RBS Greenwich Capital.

Any reluctance by Fed officials to ease in September, as expressed by a number of FOMC members ... has just melted away, and policy-makers will be much more open to the possible need for multiple eases based strictly on the economic environment, Stanley said.

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