Plosser: Mustn't forget importance of price stability

ROCHESTER, N.Y. Dec 2 (Reuters) - The U.S. economy is not facing a serious threat of deflation but the Federal Reserve could help ward off any risk by credibly committing to prevent a broad drop in prices, and an inflation target could help, a top Fed official said on Tuesday.

The central bank, as it combats the current financial turmoil, should keep in mind that price instability -- whether inflation or deflation -- can itself be a significant source of financial instability, Philadelphia Federal Reserve Bank President Charles Plosser said in remarks prepared for delivery to an economic seminar.

He said to help anchor inflation expectations and ward off any deflation risk, "the Fed must credibly commit to preventing sustained deflation from becoming widely anticipated, just as it must prevent sustained inflation from becoming widely anticipated," he said.

Plosser added that an inflation target, which he has argued for in the past, would be "just as valuable in preventing expectations of deflation from materializing" as it would expectations of inflation.

Since the Fed's current monetary policy and extraordinary lending facilities are injecting large amounts of liquidity into the economy, "the central bank will need to begin withdrawing that liquidity when financial markets begin to stabilize or risk fueling renewed inflationary pressures down the road."

Plosser said he expects economic growth to continue to be weak over the next several quarters before improving in the latter part of 2009 and then returning to near-trend growth in 2010 and 2011. He said neither businesses nor consumers have much confidence in the prospects for the economy in the near-term.

Plosser, a voting member of the central bank's Federal Open Market Committee in 2008, is one of the Fed's staunchest inflation hawks.