The Federal Reserve is expected to chart a new course on Tuesday and cut benchmark interest rates for the first time since mid-2003 to protect the economy from a housing downturn and jittery credit markets.

Fed Chairman Ben Bernanke said late last month the central bank stood ready to act as necessary to limit damage to the broader economy from the housing slump and turbulence in credit markets nervous about a wave of mortgage delinquencies.

Bernanke's remarks were seen as opening the door to lower rates and a report on August 7 showing the economy shed jobs in August for the first time in four years was seen as cementing the case for cutting overnight borrowing costs from their current 5.25 percent level.

The only question remaining seemed to be how large a reduction may be in store. Through last week, interest rate futures markets showed investors saw a somewhat greater probability of a half-percentage point cut in the overnight federal funds rate than a quarter-point.

However, futures dealers on Monday trimmed their bets of aggressive action and left the market almost evenly poised between a quarter-point and a half-point reduction.

"If the Fed only cuts rates by (a quarter-point), even with a strongly worded ... statement to commit to more easing if need be, there could be a significant disappointment trade in the financial markets, especially stocks," said Joseph LaVorgna, chief U.S. economist with Deutsche Bank in New York.

DIFFERING VIEWS

Comments by Fed officials, even after the weak employment report showed housing-related woes taking a toll on the broader economy, suggested they hold differing views on the appropriate monetary tonic.

San Francisco Federal Reserve Bank President Janet Yellen said there was evidence of "significant downward pressure" on the economy. In contrast, Dallas Fed President Richard Fisher said the economy "appeared to be weathering the storm thus far."

The last time the Fed lowered the bellwether federal funds rate was in June 2003, when it made the last of 13 reductions over two-and-a-half years that took borrowing costs to a 1958-matching low of 1 percent.

Former Fed Chairman Alan Greenspan, in interviews promoting his memoir, said Bernanke's Fed faces more risks from inflation now than he did during that rate-cutting spree in 2001-2003.

"We could ease without fear of stoking inflationary pressures," he told Reuters on Monday. "We couldn't do that in today's environment."

The Fed has held the federal funds rate, its main tool for influencing the economy steady since June of last year. However, it lowered the discount rate that governs direct Fed loans to banks in mid-August in an effort to unfreeze credit markets unsettled by mortgage defaults.

A cut in overnight rates on Tuesday would mark a sharp shift for the U.S. central bank, which said after their last regularly scheduled meeting on August 7 that inflation remained their predominant concern.

The Fed's policy-setting panel, however, said on August 17 that tighter credit conditions had "appreciably" raised the risk that the economy could stumble badly.

Inflation Deutsche Bank Ben Bernanke