John W. Schoen Senior producer • Profile • E-mail

Tuesday’s report that inflation appears to be under control will give the Federal Reserve’s interest rate-setting committee a little breathing room to make a widely-expected cut in its target federal funds rate for the first time in more than four years.

Forecasters are divided on whether the Fed will cut the benchmark rate by a quarter-percentage point or a more aggressive half-point at its policy meeting Tuesday, as central bankers respond to the first economic crisis since Chairman Ben Bernanke took office 19 months ago.

No matter which course they choose, central bankers still face significant risks. A course of gradual rate cuts could come too slowly to keep the slowing U.S. economy from being dragged into a downturn by the housing recession. On the other hand, rapid, aggressive cuts could spark another round of the kind of easy credit that created the housing bubble — and risk eroding gains in the Fed’s hard-fought battle to keep inflation under control.

The Fed’s rate-setting Open Market Committee got two more pieces of economic data to chew on ahead of Tuesday’s widely-watched rate announcement, which is expected at 2:15 p.m. ET. Wholesale prices fell by 1.4 percent in August, led by a big pullback in energy prices; even without that drop, so-called "core" inflation rose just 0.2 percent, according the Labor Department.

Meanwhile, the ongoing mortgage mess continued to widen in August. As the financial markets remained skittish about the risk of rising defaults, the number of foreclosure filings more than doubled from a year ago and jumped 36 percent from July, according to a RealtyTrac, a Web site that specializes in foreclosures.

As a result, Fed watchers say, the central bank is fighting a battle on two fronts. On one side, it is trying to push money into the banking system, recently cutting the rate on direct loans to banks through its so-called discount window, to calm the storm that hit the financial markets a month ago.

Those moves to pump money into the banking system have already pushed the cost of money well below the Fed’s official target rate. According to the Fed’s own data, the “effective” federal funds rate fell as low as 4.54 percent Aug. 14 as the central bank added liquidity to put out the fires sweeping through money markets.

The Fed tries to maintain its target rate through daily sales or purchases of Treasury securities from primary dealers, adding or draining cash to try to balance the supply of money with demand.

Though the target rate has since moved back above 5 percent, some analysts suggest that the widely expected quarter-point cut Tuesday would merely ratify what is already happening in the financial system. That has led to some speculation that the FOMC could move more aggressively with a half-point cut in the federal funds rate target.

Still, the Fed remains wary of letting up on its other perennial battle front — the fight against inflation. Despite Tuesday's good news on wholesale prices, oil prices are moving higher again — breaking $80 a barrel earlier this month. If the Fed cuts rates too far, it risks creating another credit bubble, or stoking inflation.

Former Fed Gov. Wayne Angell, now a private economist, believes the central bankers can’t have it both ways.

“It's just nonsense to say that the Fed can supply reserves to the discount window and to open market operations and without affecting the target (federal) funds rate,” he said.  “There is only one monetary policy. And this monetary policy is apparently confusion.”

Regardless of what the FOMC announces as its target rate, Fed watchers will also be scrutinizing the statement that accompanies the new rate — looking for clues about the outcome of the next regularly scheduled meeting six weeks from now.

“I would like to see the Fed (cut a half point),” said former Fed Gov. Lyle Grimly, now a senior adviser at Stanford Washington Research Group. “But I think the key issue if they go (a quarter-point) is whether the (press) release indicates more help is on the way if needed.”

Despite the recent addition of cash to the U.S. banking system, the global credit markets remain skittish following the implosion of subprime mortgage-backed bonds and the collateral damage to hedge funds, banks and other investors that are holding them. A widening fear about the prospect of further defaults rocked the stock and bond markets last month and raised market-based rates for some other types of lending.

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