While most investors are banking on a cut of at least a quarter percentage point in the benchmark fed funds rate, many think a deeper reduction is needed to unfreeze credit markets and boost confidence.
On Thursday, President George W. Bush announced a plan to stem U.S. home foreclosures, sending stocks surging on optimism it would keep the economy from sliding into a recession.
"The big focus next week is the Fed meeting," said John Praveen, chief investment strategist at Prudential International Investments Advisers LLC in Newark, New Jersey.
He said that while the market was pricing in an interest- rate cut, there was still speculation about how big such a cut would be and whether the Fed also would cut the discount rate.
Encouraging data this week, including a resilient payrolls report on Friday, eased some concerns about the economy, decreasing the likelihood of an aggressive 50-basis-point cut in the fed funds rate.
Based on December fed fund futures, the likelihood of a 50- basis-point rate cut stood at 41 percent at midday on Friday, down from 65 percent a week earlier.
The fed funds rate for overnight bank loans now stands at 4.50 percent, following two back-to-back rate cuts -- 25 basis points on October 31 and 50 basis points on September 18.
The discount rate, which is the rate the Fed charges banks for emergency loans, now stands at 5.00 percent, following a 25-basis-point cut on October 31.
While investors are primarily focusing on a potential rate cut on Tuesday, they will also be closely watching inflation data later in the week.
The Labor Department will release its Producer Price Index for November on Thursday, and the Consumer Price Index is due on Friday. The consensus forecast is for an increase of 1.5 percent in overall PPI and a 0.2 percent gain in core PPI, which factors out volatile food and energy prices.
The overall CPI is expected to rise 0.6 percent, while core CPI is forecast to gain 0.2 percent.
Monthly data from the Commerce Department, due on Thursday, could also move the market, given concerns about consumer spending, Praveen said.
Retail sales are expected to have risen 0.6 percent in November, at the start of the holiday shopping season, up from a 0.2 percent gain in October, according to the consensus forecast of economists polled by Reuters.
Other economic data scheduled for next week includes pending home sales for October on Monday, which if very weak, would add to calls for a big rate cut on Tuesday. They are expected to fall 1 percent.
Industrial production for November is due on Friday. An increase of 0.1 percent is forecast, an improvement from October's reading of -0.5. Capacity utilization is seen holding steady at 81.7 percent.