Fed, ECB prepare to tackle deflation head-on

By Ros Krasny and Alister Bull

SAN FRANCISCO (Reuters) - Officials from the Federal Reserve and the European Central Bank on Sunday vowed to fight the damaging effects of deflation as the global economy suffers a deep and lengthy recession.

In just a few months, central bankers' concerns have flipped from fighting inflation to staving off possible deflation -- a condition in which falling prices cause consumers and businesses to delay purchases, resulting in an even steeper economic downturn.

Both Janet Yellen, president of the San Francisco Federal Reserve Bank, and Lucas Papademos, vice president of the ECB, highlighted the risks of deflation at the annual meeting of the American Economics Association.

"It is increasingly likely that inflation will fall to undesirably low levels," Yellen said at the meeting in San Francisco.

She said the Fed would likely expand its raft of unconventional monetary policy measures now that its cycle of interest rate cuts has hit rock-bottom.

She also urged an aggressive spending program by the administration of President-elect Barack Obama, as she gave a dismal assessment of the economy. Yellen appeared to discount some current forecasts that U.S. growth would start to recover in the second half of 2009.

"The financial and economic firestorm we face today poses a serious risk of an extended period of stagnation -- a very grim outcome," she said. "Even with vigorous Fed action to restore credit flows, an extended period of economic weakness is likely."

"I'm strongly supportive of a substantial fiscal stimulus package," Yellen said. "If ever, in my professional career, there was a time for active, discretionary fiscal stimulus, it is now."

The ECB's Papademos, meanwhile, said that more ECB interest rate cuts may be needed to support the euro zone economy and keep deflation at bay.

"We will do what is necessary, in terms of the timing and in terms of the size (of interest rate policy action) to ensure that price stability is preserved," he said.

Unlike the Fed, which in December reached the zero-bound on interest rates and is pushing headlong into a type of "quantitative easing" to support U.S. growth, the ECB still has some arrows left in its rate-cutting quiver.

The ECB has cut its benchmark interest rate by 1.75 percentage points in the past two months, to 2.5 percent. Markets now expect another 50 basis point cut at the bank's next policy meeting, on Jan 15.

SUPPORT FOR STIMULUS

Yellen was the second Fed official this weekend to urge aggressive fiscal measures to complement the central bank's ongoing monetary policies.

On Saturday, Chicago Fed President Charles Evans said that programs to support growth "must be large in order to be effective and to instill badly needed confidence," given the severity of the downturn.