Twenty-four hours ahead of tomorrow’s decision on US interest rates by the Fed (announced at 6.15am tomorrow, our time), a leading Wall Street investment bank is now predicting a ‘mild’ recession.

Morgan Stanley’s US economics team, led by chief economist Dick Berner, changed their call in a report issued a few hours ago in the US. They say America will have a sharp slowdown in business investment; sliding personal consumption brought about by the impact of the housing slump will continue to spread.

Morgan Stanley thus joins Merrill Lynch which forecast a recession a week ago. Goldman Sachs reckons there’s a 40-45% chance of a recession even if the Fed cuts rates quickly to 3% next year.

Morgan Stanley believes the Fed will cut the Federal Funds rate by 0.25% tomorrow and the discount rate by half a per cent, but other analysts still say the Fed could even drop the Federal Funds Rate half a per cent to put itself “ahead of the game” in grappling with the slowdown.

“We’re changing our calls for US growth and monetary policy,” noted the Morgan Stanley report. “Since the shock of tighter financial conditions surfaced in August, we’ve incrementally reduced our outlook for future growth. But the time for incremental changes is over. A mild recession is now likely: We expect domestic demand to contract by an average 1% annualized in each of the next three quarters, no growth in overall GDP for the year ending in the third quarter of 2008 and corporate earnings to contract by 5-10% over that longer period. Three factors have tipped the balance to the downside: Financial conditions continue to tighten, domestic economic weakness is broadening into capital spending, and global growth — for us, long the key bulwark against a downturn — is slowing.”

“Slipping sales and tightening credit are pushing companies into liquidation mode, especially in motor vehicles,” it said. (US car companies are cutting production next month because of slowing sales). “High (interest) yield spreads have widened even more significantly. The absolute cost of borrowing is higher than in June.”

“As delinquencies and defaults soar, lenders are tightening credit for commercial, credit card and auto lending, as well as for all mortgage borrowers,” said the report, written by the group led by the bank’s chief US economist Dick Berner.

It said the foreclosure rate on residential mortgages had reached a 19-year high of 5.59%, driven by the failure of subprime mortgages in the third quarter while the glut of unsold properties would lead to a 40% fall in housing construction.

“We think overall housing starts will run below one million units in each of the next two years — a level not seen in the history of the modern data since 1959,” the report said.

Morgan Stanley says the collapse of the US commercial paper market (down more than a third since August) has now continued for 17 weeks and suggests a “fundamental deleveraging of the banking system”.