There will be an unseen participant at the meeting of the Federal Open Market Committee when it convenes Tuesday at 8:30 a.m.--an 800-pound gorilla named Lehman Brothers (LEH).

And, while the Wall Street chaos may dominate the discussion, the FOMC still has fundamentals with which it must deal: a drastic slowdown in the economy--exacerbated since it met last on Aug. 5--and on-again, off-again inflation threats. The ongoing credit and liquidity crunch may though overwhelm the numbers and force the FOMC into yet another rate cut.

Leading up to August meeting, the economic data while far from positive, was nowhere near as negative as its been in the last couple of weeks--and then, the FOMC did not have to deal with turmoil in the financial markets.

Here’s a quick look at how the economic landscape has changed since the policy-makers last met on August 5.

Economic Environment (compared with Aug. 5 meeting)

Overall Economy

•         2Q 2008 GDP improvement (from 1Q) was revised higher to 3.3% (from the originally reported 3.1% growth rate); the growth though is largely perceived to be temporary, boosted by the stimulus tax rebates, the last of which were distributed in early July.

Labor Markets

•         Payroll jobs: Continued a decline in July, the eighth consecutive monthly contraction.

•         Unemployment Rate:Increased in July to 6.1%, its highest rate since September 2003, up 1.4 percentage points in the last year, the steepest one-year increase since May 2002.

•         Unemployment insurance claims: The four-week moving average of initial claims last week was 440,000, up from 420,250 just before the August 5 meeting; the four week moving average of continuing claims last week was 3,525,000, up from 3,378,00 just before the August 5 meeting

Consumer Activity

•         Wages: According to the most recent data from the Bureau of Labor Statistics, average hourly earnings rose seven cents in August for the second straight month; year-over-year though, because of a decline in hours worked, average weekly earnings are up just 3.2% (six-month moving average), down from the growth before the last FOMC meeting and the weakest growth in more than two years. Wages represent about 40% of total personal income; personal income fell 0.7% in July.

•         Personal consumption: Personal consumption--representing about 70% of the economy--rose just 0.2% in July, the weakest start to a quarter since 4Q 2007, which coincidentally was a quarter of negative economic growth. Retail sales in August--about 40% of personal consumption spending--fell for the second straight month, the first back-back monthly declines since May-June 2006.

•         Confidence: Surveys from both the University of Michigan and the Conference Board at the end of August reflected a slight uptick in confidence in August; the University of Michigan preliminary September survey showed a sharp jump as gasoline prices fell.

Inflation

•         CPI: Headline inflation rose in July to 5.5% (August data will be reported Tuesday morning), its highest level since January 1991. Core inflation ticked up to 2.5%, its highest level since March 2007. Both inflation measures are higher than they were before the FOMC’s last meeting.

•         PCE: The FOMC’s more favored inflation measures of inflation--tracking personal consumption spending--also rose smartly in July; August data will not be reported until the end of this month

Housing

•         Home values: continued to decline since the last FOMC meeting, but at a slower pace.

•         Home sales: New and existing home sales reported since the last FOMC meeting both increased as prices rose for new homes but fell for existing homes.

•         Mortgage rates: Interest rates for both fixed and adjustable rate loans ticked down slightly but lending standards tightened.

Traders at the Chicago Board of Trade who bet on the Fed Funds rate on Monday seemed to favoring an interest rate cut from the current level of 2.00% and, to an extent, history is on their side.

In March, just before the Bear Stearns takeover, the FOMC said it was “monitoring market developments closely and will continue to provide liquidity as necessary to promote the orderly functioning of the financial system.” When the JPMorgan deal was announced, the FOMC announced a 25-basis-point cut in the discount rate, and then two days later, cut the Fed Funds rate by 75 basis points at a regularly scheduled meeting. The Fed this past Sunday released a statement, but made no reference to the funds rate or any suggestion it would temporarily ignore the target funds rate and add to liquidity.

The FOMC may be reluctant to cut the funds rate in response to the market chaos. If equities fall sharply and credit spreads surge, though, the Fed officials probably would cut the target funds rate at Tuesday’s meeting. Absent such events, it is more likely to issue a more dovish statement, reiterating willingness to step in quickly. The reluctance to cut the funds rate likely reflects a distinction between broad macro weakness (for which the Fed Funds rate is a policy tool) and financial sector difficulties (where more targeted tools such as the discount window and any of the new programs can be used). Though financial sector difficulties can lead to broad macro weakness, a cut in the Fed Funds rate could be justified as a pre-emptive strike.

The idea that the FOMC will cut rates Tuesday is supported by several economists. IFR Markets sees a quarter-point cut to 1.75%, ING at least that much, Merrill Lynch a half-percentage-point reduction and HSBC a cut by a full percentage point to 1.00%, which would be the lowest rate since June 2003.

More attention will be paid to the statement issued by the Committee when its meeting ends. In August, the FOMC was somewhat upbeat, contending that “economic activity expanded in the second quarter, partly reflecting growth in consumer spending and exports” but at the same time noting “labor markets have softened further and financial markets remain under considerable stress.” The FOMC said, though, that “over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth,” overcoming “tight credit conditions, the ongoing housing contraction, and elevated energy prices.”

The Committee was sanguine about inflation downplaying increases in prices indexes, saying it “expects inflation to moderate later this year and next year.”

The FOMC gave itself wiggle room asserting “although downside risks to growth remain, the upside risks to inflation are also of significant concern.”

That of course, was before Lehman.