NEW YORK -- The Federal Reserve may have taken on more than it bargained for in its inflation battle.

Signs of a crumbling U.S. housing market and worries that the slump may hurt the overall economy are feeding the idea the central bank will be forced to trim short-term interest rates sooner than many had forecast.

"If the Fed feels that there is enough downward pressure on the economy from housing - and there's enough indication that inflation is not the concern that they thought it was - I could see them lowering interest rates," said Eric Belsky, executive director at Harvard University's Joint Center for Housing Studies in Cambridge, Massachusetts.

Federal Open Market Committee officials remain concerned about inflation but acknowledged risks to the growth outlook this week by voting to keep the overnight federal funds rate target at 5.25 percent for a second consecutive meeting.

In its accompanying statement, the FOMC said that "moderation in economic growth appears to be continuing, partly reflecting a cooling of the housing market."

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A deluge of data showing a surge in the number of homes for sale and dwindling demand has some analysts acknowledging that the once-robust market is not just cooling from its record five-year run, but is headed for a deep-freeze.

The Fed may therefore start cutting rates sooner than many had expected to limit a contagion to the overall economy.

"Historically ... it's typical for interest-rate-sensitive sectors such as housing and automobiles to lead the economy into a recession," Belsky said. "If they cut rates it'll make the housing slowdown a little shallower."

Most Wall Street economists are expecting the Fed to start cutting rates in early 2007. The housing slump has some, such as BNP Paribas, predicting a rate cut as soon as December.

"Housing is the first sector that has showed a significant weakening as a result of interest-rate pressures," said Brian Fabbri, chief U.S. economist at BNP Paribas in New York. "The Fed will need to see if these problems in housing will spread to other sectors."

Futures contracts show traders see around a 10 percent chance of a quarter point rate cut in December.

HOUSING ATM IS CLOSED

The Fed played a pivotal role in the housing boom by keeping borrowing costs historically low for years, spurring record demand for home loans.

"Demand overshot supply, and what we are seeing right now is a correction," said Elisabeth Denison, an economist at Dresdner Kleinwort Wasserstein in New York, adding that a slowdown could shave 1.0 percentage point off U.S. gross domestic product in the third and fourth quarters.

The housing boom, considered to have begun in 2000, benefited homeowners and supported an economy that was recovering from recession.

As home prices tallied double-digit percentage gains in most of the country, consumers used their homes as virtual ATM machines, borrowing against the rising value and spending the proceeds on an array of products.

Consumer spending makes up two-thirds of the U.S. economy, and a reversal of the housing-driven "wealth effect" seems probable, given that prices rose just more than 1.0 percent in the second quarter, the smallest gain in six years, according to the Office Of Federal Housing Enterprise Oversight.

In this light, gauges of housing slated for next week may prove critical to Fed policy.

On Wednesday, the Commerce Department will report on August new home sales, which account for about 15 percent of the market. Though that's a small part of overall sales, new homes generate more economic activity than existing homes by creating construction jobs and boosting sales of consumer durables.

The National Association of Realtors will release data on August existing home sales on Monday.

"Data on housing can be very volatile, so relying on one piece of data can be very deceiving," DKW's Denison said.

LOWER RATES MAY BUFFER BLOW

Treasury yields, which are linked to mortgage rates, plummeted this week and have trended lower since June as soft economic data allayed concerns about inflation. The recent drop seems to have had an immediate impact on home-loan demand.

The Mortgage Bankers Association, an industry trade group, said U.S. home mortgages rose for a third straight week. The seasonally adjusted index of total mortgage applications, including refinancings, rose 2 percent in the week ended Sept. 15 to 595.8, its highest level since April, the MBA said.

Yields on the 10-year Treasury note fell to their lowest in more than six months on Friday, which may spur even more loan demand in the coming weeks.

"It is bumpier than a shallow downturn for housing, but it doesn't yet shape up to drive the economy into a recession," said Harvard's Belsky. "But stay tuned."

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