Deflation a key risk in 2009, argues St. Louis Fed President James Bullard

Further disinflation and a possibly "deflationary trap" is a key "near-term risk" for 2009, said James Bullard, president of the St. Louis Federal Reserve Bank, on Tuesday during a speech in New York. Bullard warned,

"Expectations of deflation for the next five years may feed into real interest rates, driving real rates higher just at the time monetary policy would like to move them lower."

Deflation is a persistent decrease in general prices, or the opposite of inflation. Falling prices may seem like good news for consumers, but only to a certain point. If prices mark sustained deflationary levels that strike below the cost to produce goods and services, further economic turmoil can ensue with production cuts, payroll reductions and deepening unemployment. Deflation can intensify debt by making it more expensive, cripple equity and widen home foreclosures.

Bullard addressed the New York Association For Business Economics where he said the recession would likely continue at least to the first half of 2009, and that there is a risk for sustained disinflation and a possible deflationary cycle similar to what the Japanese experienced after 1990.

Bullard noted that the most recent statistics already confirm core inflation is running near zero to slightly negative, and when coupled with the global recession,

"Suggests that there is a risk that core prices may continue to stagnate or decline slightly for some time to come," Bullard said.

"Should lingering financial turmoil continue to weigh on the economy and stretch the recession out still longer, the zero or negative inflation could continue through 2009. Over that time frame, deflationary expectations could become entrenched," Bullard warned.

Lowering interest rates is the typical vehicle used by the Fed to stir inflation and combat deflation. However, the Fed cut rates to 0-0.25% in December to help spur the economy — which is not yet spurred — taking any rate adjustment virtually out of a deflation fix formula.

Bullard suggests an approach he would not take in "normal times" and one undertaken in October 1979 by Fed Chairman Paul Volcker is now viable. Bullard said the Fed should set quantitative targets for monetary policy, beginning with the growth rate of the monetary base. Or in clearer terms, create more money.

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