Inflation becomes afterthought as credit crisis worsens

NEW YORK (Reuters) - Fire up the chopper and man the printing press, the government is now attacking the financial crisis head-on, with "helicopter Ben" Bernanke strapped in to the co-pilot's seat.

Before he became Federal Reserve chief, Bernanke incurred the ire of inflation vigilantes for his 2002 mention of a "helicopter drop" of money in a discussion of possible strategies for fighting a deflationary economic spiral like the Great Depression.

The comment may be ringing in the ears of some hardliners after the U.S. government approved a $700 billion bank bailout last week and the Federal Reserve announced a corporate finance rescue on Tuesday, but the financial system's dire condition has sounded a louder alarm.

"If this doesn't work then certainly deflation is a much bigger concern than inflation," said Brian Levitt, economist, OppenheimerFunds, New York.

Under last week's plan, the Treasury will attempt to revive paralyzed credit markets by buying up mortgage-related securities that have lost their value due to the worst U.S. housing slump since the Great Depression.

The Federal Reserve said on Tuesday it would begin buying the short-term debt many companies use to fund their day-to-day operations.

The initiatives were the latest in a series of other bailouts and rescues, including the nationalization of housing finance giants Fannie Mae (FNM.N) and Freddie Mac (FRE.N).

The total cost of all of the government's efforts to avoid a financial collapse could approach $2 trillion.

PRINTING MONEY

Normally such a massive rise in government borrowing and spending might be inflationary. Indeed, Bernanke's 2002 comment was considered controversial because it suggested the Fed might resort to printing money to get out a deflationary rut.

In the near term, however, economists say the bigger danger is deflation. Consumer inflation remains elevated after record-high energy prices this year but the effects of the credit crisis are more likely to damp this down.

In fact, house prices and the stock market are tumbling while companies and consumers are finding credit more difficult to obtain as the crisis deepens.

These are hardly inflationary developments, and neither is the stunning $50-dollar drop oil prices have seen in the last three months, though by many measures, the government's plan would be considered inflationary.

"Right now we're getting the big benefits from the decline in oil prices, but the longer-term consequences of this are clearly going to be inflationary" said Conrad DeQuadros, senior economist at RDQ Economics.

"We have massive amounts of liquidity that is being pumped into the economy globally. Central banks are likely to remove this liquidity very slowly. So right now the focus is clearly not inflation but I think it will be down the road."

VICIOUS CYCLE

For some, the latest developments in markets and the economy bring to mind the last extended period of deflation in the United States, which occurred during the 1930s and was characterized by a vicious cycle of plummeting demand, falling prices, and rising unemployment.

Officials find the prospects of a deflationary crisis particularly troublesome because it reduces the effectiveness of traditional monetary policy implemented through interest rates.

It is this environment that market strategists believe should be kept in mind as the government cranks up its issuance of Treasury debt paper to finance its war on the credit squeeze.

"Right now there is incredible demand for Treasuries. There really aren't many substitutes," said Carl Lantz, U.S. interest rate strategist at Credit Suisse in New York.

"The corporate market is pretty much shut down so Treasuries are kind of the only game in town. So if you think about supply more holistically from the supply of U.S. dollar fixed income, it's actually relatively anemic right now."

However, there will be a price to pay for this bailout, say analysts. It might not be soon, and might even be preferable to the current dilemma facing officials, but it is most likely to be in the form of higher inflation.

"The Fed has had to create a lot and will have to create a lot of money to get these bad debt instruments off the books and get the system working again," said Kim Rupert, managing director of global fixed income analysis at Action Economics LLC in San Francisco.

"There are a lot of adverse consequences to the ($700 billion) plan, the inflationary impact for one. We're going to get massive Treasury supply over the next year or two. Those are going to be things we'll have to digest because of the need to do this package."

(Additional Reporting by Pedro Nicolaci da Costa)