Opposition parties say issuing an emergency decree would be drastic and retrogressive.
During a state of emergency, the government can restrict the freedom to move, rally, engage in political activities or form groups as well as take a number of other measures, including restricting the parliament's right to make laws.
Most critically, though, it allows Musharraf to dissolve parliament and postpone, or even suspend elections due later this year.
Under Pakistan's constitution, the president may declare a state of emergency if it is deemed that the country's security is "threatened by war or external aggression, or by internal disturbance beyond" the government's authority to control.
Earlier on Thursday, Tariq Azim, the minister of state for information, had said emergency rule may be declared due because of "some external and internal threats and the law and order situation".
The president has seen declining support at home since a failed attempt to sack the country's chief justice and the storming of Islamabad's Red mosque sparked nationwide protests.
More than 100 people died when government troops stormed the mosque.
Since then, hundreds more have been killed in a wave of bombings and suicide attacks, and a peace deal with tribal leaders in the country's north-west has collapsed.
Kamal Hyder, Al Jazeera's correspondent in Islamabad, said: "The chief justice who was fired was restored by the supreme court, the handling of the red mosque was criticised, after that came the deal or no deal with Benazir Bhutto ... and now there is talk of emergency rule, and again denial of that.
"There is quite a lot of political awareness in Pakistan ... and they are all saying the same thing. That the time has come for Musharraf, and the regime, to say goodbye."
Critics in Pakistan have said the threat of an announcement of a state of emergency was desperate bid by Musharraf to cling to power amid challenges from the country's secular pro-democracy movement.
It has also been viewed as a warning by the president to the supreme court, who began hearing a plea on Thursday for Nawaz Sharif, the prime minister Musharraf ousted eight years ago, to be allowed to return from exile.
|Pakistan's stock market slumped on Thursday|
amid emergency rule rumours [AFP]
Speaking to Al Jazeera on Wednedsay, Sharif said: "Musharraf is doing all the wrong things these days. He is desperate, and he is acting desperately.
"The sooner Mr Musharraf steps down, the better it is for Pakistan and also for the region."
Official sources said Musharraf called a meeting of cabinet ministers and the attorney-general at his camp office in Rawalpindi, near the capital Islamabad, before deciding against emergency rule.
The Karachi stock market, which had shrugged off political uncertainties for weeks as it hovered near life highs, slumped by more than four per cent within minutes of opening on Thursday.
Benazir Bhutto, a former prime minister and self-exiled leader of the largest opposition party, told Geo News overnight that it would be bad for a nation looking forward to greater democracy.
Source: Al Jazeera and agencies