THE MOST overpredicted recession in modern memory may finally be on the horizon -- and it could hardly come at a worse time. Sagging consumer demand, weak business profits and investment and mounting inventories provide the classic conditions for an economic downturn. To these must be added the fragility of many parts of the financial system and now a surge in oil prices arising from Iraq's attack on Kuwait. These factors both add to the likelihood of a downturn and make it more urgent to avoid one.

But a full-blown recession is not inevitable: The Federal Reserve can reduce the risk of its occurring -- and minimize the likely damage if it does occur -- by actively pushing down interest rates now. The case for easing monetary policy is not just that the risk of recession is high enough to be worrisome. It is also that many parts of the economy have become financially shaky, so that a recession would be exceptionally damaging while lower interest rates would be exceptionally helpful. Moreover, reducing rates could even keep alive hopes for deficit reduction.

To be sure, the Mideast situation further clouds the economic outlook and complicates the Fed's conduct of monetary policy. Analysts will draw parallels with 1973-74, when the first big OPEC price increase contributed to a surge in overall inflation. But that episode occurred in a very different environment. In 1973, price and wage controls were being lifted and the consumer price index was already rising at double-digit rates. These price developments, together with the tight monetary policy used to fight them, brought on a massive recession. It is too early to know what the Iraqi invasion will ultimately mean for oil prices this time. But it adds to the likelihood of recession to the extent that the prospect of added inflationary pressure inhibits the Federal Reserve from reducing interest rates.

The economy is not yet in a recession by any accepted statistical indicators. Unemployment is still relatively low -- despite last month's jump in the unemployment rate to 5.5 percent. And real GNP and industrial production both rose, albeit modestly, in the second quarter. But a close look at recent economic developments points to growing weakness in the expansion:

Consumers have run out of steam. Buying by consumers accounts for about two-thirds of total demand in the U.S. economy. Except for volatile automobile sales, consumer spending generally neither leads nor causes declines in total GNP. Yet by the second quarter of this year, real consumer spending on all major categories of both durable and nondurable goods was down, and only spending on services was still rising. When consumers get worried they tend to cut back discretionary spending -- even if their own pocketbooks have not yet been affected. Although consumer surveys are inconclusive on this point, this unusually pervasive weakness in consumer buying may reflect worries both about national developments such as the thrift crisis and about developments closer to personal experience, such as weakening house prices. Nothing is likely to cure either worry soon.

Business buying is sluggish. Spending by business on new plants and equipment declined in the second quarter. Capital appropriations, orders for capital goods, and construction contracts and declining profits all suggest weaker, not stronger, demand from this sector during the second half of the year. Commercial construction has gotten well ahead of need for office and retail space in most areas, to the point where its financing has become a serious problem for banks and other lenders. Residential construction declined in the second quarter and is heading down further. Some continued growth in exports is the only clear plus on the economic horizon.

Inventories are growing while sales are weak. The contrast between these weak final sales in most sectors and a considerable buildup of inventories in recent months is especially worrisome. Total final sales -- the sum of sales in these sectors plus purchases by government -- increased at an average annual rate of only 0.7 percent over the past three quarters, and actually declined at a 2.2 percent annual rate in the latest quarter. Since sales have been so disappointing businesses are not anxious to stock up. So the recent build-up of inventories has to be seen as largely unintended: Inventories rose because goods weren't selling, not because businesses wanted to be sure they'd be able to meet demand. Barring a renewed pickup in final sales, firms may soon cut production in order to keep inventories in line, and this in turn will reduce economy-wide employment, incomes and profits and weaken final sales still further.

So far I have described a classic business cycle in the making. At some previous times, the economy has marched up to the edge of such a downturn but not actually fallen over the cliff. When it has escaped it has generally been because the Federal Reserve aggressively reduced interest rates, as in 1985-86. Maybe this time final sales will strengthen spontaneously and interrupt the process even without lower rates. Maybe demands from abroad will expand our exports enough to overcome other weaknesses. But rather than relying on such hopes, a realistic appraisal should recognize that this time financial problems in the economy make a downturn both more likely and more damaging.

One major economic legacy of the 1980s is the high level of debt and leverage of many firms and the weak balance sheets of many financial institutions. The insolvencies that have overwhelmed the savings and loan industry are a well-documented disaster. The problems at major banks are emerging as the next bad surprise. And the bankruptcies of leveraged firms would be a feature of any future recession.

The problems of banks and related institutions are especially important now because they add to the chances of a recession. Major banks have gotten into trouble in several ways. Some of their loans were obviously very risky to begin with, others risky only after the fact. First it was Third World debt, then "oil patch" loans, then leveraged buyout paper and now construction loans in overbuilt markets. Aggressively marketed variable rate residential mortgages also added to risk by encouraging home buyers to take on escalating obligations they now find hard to meet. At present, banks in the Northeast part of the country are in the worst trouble, but California banks may be next.

These financial problems can spread to real activity in the rest of the economy through at least two channels: crumbling confidence and reduced credit availability. Although bank deposits are not at risk, insolvencies at major banks could only add to the caution of some consumers and business firms. But even without insolvencies and their effects on consumer and business confidence, some firms' ability to carry inventory and invest is almost surely being hurt by the newly found caution of bankers and bank regulators, anxious to avoid what happened to undersupervised thrifts. Other watchdog agencies may be having a similar effect in other ways. The Securities and Exchange Commission wants money market funds to hold only the top grade of commercial paper. That will add further to the cost and difficulties many firms face in borrowing for normal business purposes.

There is no simple cure for the financial excesses of the past. Soon Congress and the president must consider what systemic changes would reduce such problems in the future. But for now, lower interest rates would be a big help. They would provide some breathing space for financial firms to improve their balance sheets. They would ease the squeeze on borrowers, including new homeowners who now face sharp interest rates increases on their variable rate mortgages. They would offset some of the effects of credit rationing, and, by stimulating buying in the economy, would help avoid a recession.

Despite this picture of a growing recession risk and a pressing need for reduced interest rates, the Federal Reserve has been reluctant to lower rates. It did reduce the key federal funds rate by a tiny one-quarter percent. But Chairman Alan Greenspan emphasized that it did so only to offset some credit rationing by banks and not for the traditional reason of stabilizing a weak economy.

Ican think of three reasons for the Fed's reluctance to ease. First, Greenspan and his Board may simply see the outlook differently than I do, with little risk of recession if present interest rates are maintained. Second, they may believe that cutting interest rates now would add unacceptably to inflation, or at least interfere with the eventual slowing of inflation that they regard as their main goal. Third, having all but promised lower interest rates in return for convincing reductions in the budget deficit, they may now feel they cannot lower rates without a budget compromise.

Inflation is a legitimate concern. The underlying inflation rate has been on a plateau of 4 to 5 percent for at least half a decade now, with actual inflation varying from this mainly as oil or food prices fluctuated. The sluggishness of the expansion in recent quarters was not accompanied by lower inflation and now, with oil prices rising sharply, actual inflation rates will almost surely be up for a few months. If the economy were stronger, this inflation outlook would justify keeping policy tight. But with present weak economic prospects, and presently fragile financial conditions, inflation fighting should not be the top priority.

Finally, lower interest rates should also contribute to the objective of encouraging deficit reduction. The budget negotiations are dragging and even an optimist has to believe that the earliest any measures could be debated and voted on is November, in a post-election session. If the economy is clearly turning down at that time, legislators, who are not anxious to cast unpopular votes to cut the deficit anyhow, will be susceptible to arguments that the economy is too weak to withstand tax hikes or spending cuts. Reducing interest rates so as to keep the economy as healthy as possible -- and out of the budget debate -- is now the best help that the Fed can give to the deficit reduction cause.

George Perry is a senior fellow at the Brookings Institution.