PIMCO's McCulley-Fed must have bold plan in mind

CHICAGO, July 14 (Reuters) - The U.S. Federal Reserve may need to consider highly unorthodox measures to boost the economy if a "liquidity trap" drags on, said Paul McCulley, managing director of the giant bond firm PIMCO.

In a newsletter posted on Tuesday, McCulley said the Fed should have a plan in mind "if and when" the U.S. economy seemed set to languish in a way similar to Japan's so-called "lost decade." of the 1990s.

Liquidity trap is a term used to describe a situation where a country's nominal interest rate has been lowered to, or close to, zero but still fails to stimulate the economy.

The Fed has set its benchmark lending rate in a range of zero to 0.25 percent since December 2008.

For now, pressure on personal income continues from "massive unemployment and underemployment," which is pushing wage growth toward zero, McCulley said.

"This is not the stuff of a self-sustaining revival in aggregate demand," he added.

"America is in a liquidity trap, driven by private sector deleveraging borne of asset price deflation, meaning that private sector demand for credit is axiomatically flat to negative, despite a fed funds rate pinned against zero."

McCulley cited a speech by Ben Bernanke in May 2003, when the Fed Chairman, then a Fed Governor, suggested ways that Japan could climb out of a deflationary hole.

Bernanke urged the Bank of Japan to consider reflationary policies -- setting a price level target that would push inflation above the desired long-term rate for a time -- and also suggested that a tax cut could be useful.

"Bernanke recognized that such a policy could unmoor long-term inflation expectations, creating a deleterious rise in long-term interest rates," said McCulley. "But in his view this was a risk worth taking."

McCulley said the extreme measures advocated for Japan "do not translate fully to the United States. But they do translate a lot more than the consensus is even willing to discuss."

(Reporting by Ros Krasny, editing by W Simon)