(Updates with meeting resuming, inflation, housing data)
By Alister Bull
WASHINGTON, Dec 16 (Reuters) - The U.S. Federal Reserve is expected to lower interest rates closer to zero on Tuesday and point toward emergency tools it could deploy to end a year-long recession, with room to cut borrowing costs running out.
Economists expect the central bank to lower its target for benchmark overnight rates by at least a half-percentage point, to 0.5 percent, and suggest it will aggressively use unconventional measures to restore growth.
"This meeting will be an important step toward a new policy regime in which the emphasis shifts from the federal funds rate to ... balance sheet actions," said former Fed Governor Laurence Meyer.
A Fed official said policy-makers resumed their two-day meeting at 9 a.m. (1400 GMT). The rate decision and an accompanying policy statement are expected around 2:15 p.m. (1915 GMT).
Shortly before the meeting began, the government said construction starts on new U.S. homes hit the lowest level on records dating to 1959 in November, while consumer prices fell a record 1.7 percent as energy prices continued to crater. For details, see [ID:nN1620608]
The data signals a deepening in the U.S. recession, backing a case for aggressive and nontraditional actions by the central bank. Some economists see fourth-quarter U.S. output shrinking at a 6 percent annual pace or more.
"There's zero sign of any stabilization," said Brian Dolan, chief currency strategist at Forex.com in Bedminster, New Jersey.
Unconventional measures could include so-called quantitative easing, which recalls the emergency steps taken by Japan earlier this decade to expand the supply and circulation of money to end a period of stagnation and deflation.
Fed Chairman Ben Bernanke previewed possible unconventional steps the U.S. central bank could take earlier this month.
He said the Fed could directly intervene in markets to lower borrowing costs and stimulate the economy by purchasing large quantities of U.S. government bonds or by buying private sector debt that investors have shunned.
"Our nation's economic policy must vigorously address the substantial risks to financial stability and economic growth," Bernanke said.
With yields on U.S. Treasury debt already very low, economists say the Fed may want to take aim at mortgage-backed securities. Increasing demand for these bonds should help to reduce mortgage rates, spurring demand for homes and hopefully halting the slide in housing prices.
In its statement, the central bank could indicate a willingness to keep rates low until the economy is firmly on the road to recovery.
It adopted a similar tactic in 2003 when it cut rates to 1 percent and vowed to keep them low for a "considerable period" in an effort to hold down long-term rates. This time it would more likely condition any commitment to the economy's health.
The housing collapse has led to the worst financial crisis since the Great Depression and tipped the U.S. economy into a recession last December. The downturn is already the longest since the 1980s and economists hold out little hope an expansion can take root before mid-2009.
The Fed has already reduced the overnight federal funds rate by 4.25 percentage points, to 1 percent, since September 2007.
It also has engaged in a degree of quantitative easing by pumping more than $1 trillion into financial markets, inflating the money supply and almost doubling the size of its balance sheet over the past year.
The rapid increase in the supply of money in normal times might stoke fears of inflation. But that seems a distant problem at a time when banks are reluctant to lend.
In fact, some economists predict the United States could suffer a deflationary period in 2009, as tumbling oil and commodity prices, alongside increasing slack in the economy, deliver a sustained fall in general prices. (Editing by Neil Stempleman)