Fed and Bank of Japan officials flag deflation risks

EVANSVILLE, Ind./TOKYO (Reuters) - U.S. Federal Reserve and Bank of Japan officials said they were on alert for signs of deflation and grappling with how the central banks would keep it at bay as interest rates approach zero.

St Louis Federal Reserve President James Bullard said the Fed may have to resort to so-called quantitative easing that relies on massive liquidity injections into the banking system.

Bank of Japan Governor Masaaki Shirakawa said such injections had helped pull Japan out of a decade of deflation that began in late 1990s, but he would not comment on whether it be the best response to a slump sparked by the global financial crisis.

Central bankers, who only few months ago were struggling to contain an inflation flare-up stoked by soaring commodity prices, are now trying to prevent global market mayhem from degenerating into a cycle of falling prices and economic output.

Consumer demand is plummeting across the industrialized world and U.S. consumer prices fell at a record pace in October, but Bullard said deflation was still a remote risk.

"It would take some doing to get some deflation," he told a regional economics conference.

"If we do our job it won't happen and we're dedicated to that."

The task of avoiding deflation has been complicated by sharp interest cuts by major central banks to avert economic collapse after a credit squeeze triggered by U.S. mortgage defaults threatened to rupture the global financial system.

The Fed's policy rate is at 1 percent and some economists believe it will drop to zero over the next three months.

"At least over the near term, any additional influence through interest rate reductions will be limited and the focus of monetary policy may turn to quantity measures," said Bullard who is not a voting member of the Fed's policy committee this year.

The Bank of Japan had resorted to hefty liquidity injections during the 1990s to spur price growth once official interest rates reached zero.

The Fed and other central banks are already flooding the banking system with cash to prod banks into lending to each other. But these funds are still lent at a cost. In Japan, during quantitative easing, banks received free cash in the hope that it would spur credit growth and consumption.

"By announcing and maintaining targets for key monetary quantities, the Fed may be able to keep inflation and inflation expectations near target and ward off either a drift toward deflation or excessively high inflation," Bullard said.

The Bank of Japan governor was more cautious about the best policy to tackle deflation, now that interest rates have fallen to 0.3 percent after a cut last month.

More rates cuts could disrupt the money markets, Shirakawa said on Friday after the Bank of Japan kept rates on hold.

He was also non-committal about quantitative easing.

"The BOJ decided to implement quantitative easing in the past because it was appropriate to do so in light of economic developments at the time," he said.

"As for what would be the best policy in the future, we will decide by examining economic and financial developments."

The cautious tone may reflect the BOJ's experience with quantitative easing which took years to lift Japan out of deflation, and even then barely kept core inflation above zero.

"As there is some talk about quantitative easing in the United States, the BOJ which experienced the world of zero interest rates for about five years, knows how difficult it is to provide liquidity in that kind of situation," said Susumu Kato, chief economist at Calyon Securities.

CLOSE WATCH

Asked about the risk of falling prices, Shirakawa said: "Now that raw material costs are falling, a key factor to watch is whether that would cause a knock-on effect and push down overall prices."

"We will closely watch the balance of domestic supply and demand and how people's price expectations develop," he said after the central bank kept rates steady at its policy meeting.

With Japan's economy already in a recession and oil and commodity prices in retreat, many analysts expect consumer prices to start falling again next year.

In the euro zone, lasting declines in consumer prices were also a distant threat even though prices may fall for one or two months next year, European Central Bank Governing Council member Yves Mersch was quoted as saying.

"We have to look beyond such short-term falls in prices, just as we looked beyond short-term increases when commodity prices spiked," Mersch said in an interview with news agency Dow Jones.

Euro zone inflation peaked at 4 percent in June and July, double the ECB's target and Mersch said he expected rather "welcome disinflation" than deflation, bringing price growth closer to the central bank's target.

(Additional reporting by Philip Blenkinsop in Brussels; Writing by Tomasz Janowski; Editing by Dayan Candappa)