Bold Fed still needs fiscal help

NEW YORK (Reuters) - No matter how bold the Fed's unprecedented plan to revive the U.S. economy, it is likely to take a stimulus package of as much as a trillion dollars to halt a precipitous slide into deflation.

The U.S. Federal Reserve cut interest rates to the bone on Tuesday in its efforts to halt the economy's rapid descent and said it would employ "all available tools" to end a year-long recession.

But the failure of its efforts so far to revive lending in the shaky U.S. financial system show the need for government spending to take over where monetary policy faces limits.

"In a situation as dire as this, monetary policy on its own is not adequate to the job," said Nigel Gault, director of U.S. economic research at Global Insight in Lexington, Massachusetts. "The federal government can borrow, and the federal government can effectively step in and be a spender of last resort."

"If we did nothing on the fiscal stimulus side, it would be a much bigger risk of getting into a full-fledged deflationary spiral."

Gault said he would like to see stimulus of about $700 billion to $800 billion over the next three years.

The United States last endured a period of deflation during the Great Depression of the 1930s.

Policy makers and economists fear this phenomenon of downwardly spiraling prices, earnings and economic activity because it is perhaps the most difficult problem to fix.

In such periods, banks stop lending, consumers stop spending and businesses cut investments and lay off workers.

HEY BUDDY, CAN YOU SPARE $1 TRILLION?

U.S. President-elect Barack Obama has repeatedly raised hopes of those calling for a substantial economic stimulus, promising a massive public works program to lift the U.S. economy out of recession.

On Tuesday, he warned that the central bank was running out of traditional tools for fighting recession and said other branches of government needed to step up to help.

"That's why the economic recovery plan is so absolutely critical," he said.

The Wall Street Journal reported on Saturday that Obama's team is considering a plan that might reach $1 trillion over two years.

SOME SAY WE'RE SPIRAL-BOUND

Some analysts fear the United States has already entered such a deflationary period, while others say they want more evidence, but the warning signs are clear.

Data on Tuesday showed consumer prices, a closely watched gauge of inflation, fell at a record pace in November, heightening fears of deflation.

"I think we're in a deflationary spiral that will probably go on until sometime next year," said Thomas di Galoma, head of U.S. Treasury trading at Jefferies & Co. in New York. "I think it will probably go on through the majority of 2009.

That data came before the Fed announced it cut the target for its benchmark federal funds interest rate to a record low range of zero to 0.25 percent.

It also said it will purchase "large quantities" of mortgage-related securities and is also evaluating the potential benefits of purchasing longer-term Treasuries, all part of efforts to support the financial system and the economy.

The Fed's statement noted that inflationary pressures had diminished appreciably and it expected inflation to moderate further in coming quarters.

Given that monthly prices are already declining, that certainly heightens the risks of deflation. The Fed also pledged to "preserve price stability."

"The subtext there is that the Fed is guarding against an inflation rate that is both too low and too high," said Dana Saporta, analyst at Dresdner Kleinwort in New York.

Saporta did not see a strong danger of deflation, though she argued that fiscal stimulus is still needed to get the moribund economy going.

"There is only so much the Fed can do to help homeowners and others facing loans they can't pay and a fiscal stimulus is necessary in addition (to Fed measures)," Saporta said.

A BIG ZERO

For some, the zero in the target rate and the extraordinary measures were an acknowledgment that deflation is barking at the door and that the Fed has lost control of the shrinking economy despite its considerable efforts so far.

"What they do on the funds rate is meaningless," said Michael Strauss, chief economist of Commonfund in Wilton, Connecticut.

"The fear of this economic cycle right now is could we get a risk of deflation -- of outright deflation that becomes spiraling in nature."

With the enormity of the problem increasing by the day, it is unlikely that the Fed will be able to do the job alone.

The Fed's liabilities have already burgeoned to more than $2 trillion in its efforts to stem the crisis and economists say now is the time for the government to step in with another stimulus package after one earlier this year.

"If the Fed was the only game in town on this, it might not be enough. But they are not the only game in town. We're also going to get fiscal policy stimulus," Strauss said.

"We'll probably get a trillion-dollar package."

(Reporting by Burton Frierson; Editing by Jan Paschal)