"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.

“I think lowering interest rates right now, maybe, is not the right response,” James Bullard, president of the Federal Reserve Bank of St. Louis, told an audience in Bloomington, Indiana after giving a speech on Thursday.

The Federal Reserve is naturally inclined to raise interest rates to combat inflation, and lower them to reduce the pull of downward economic activity or recession.

"We’ve already lowered rates a lot. We’ve created this low interest rate environment. It is a blunt instrument … and you’ve got this brewing inflation problem that could get out of control if we don’t keep an eye on it," he told reporters.

Current investor expectations are for an interest rate cut by as much as half a percentage point at the next Federal Open Market Committee (FOMC) policy meeting on Oct. 28-29.

Bullard, although not a voting FOMC member this year, would clearly hold rates steady. His speech before an audience at Indiana University-Bloomington was entitled "Systemic Risk: An Attempt at Perspective." It concluded with:

In summary, the near-term outlook for economic growth and inflation is above all uncertain. Two keys to future economic performance will be stabilization in housing and financial markets. Financial market turmoil has recently been severe, and the consequences of this turmoil on real economic performance entail clear downside risk. If financial market turmoil can be contained, the FOMC can turn attention to achieving better inflation results than those recently experienced. Until inflation clearly moderates, my colleagues and I will need to be especially watchful that our accommodative policy stance does not begin to worsen the outlook for long-run price stability.

In regards to the $700 billion rescue plan, Bullard said it would help banks "a lot," and that it looked like labor markets were in a recession with recent data that was "weaker than expected."