UPDATE 1-Fed's Bullard: Don't underestimate inflation risk

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By Emily Kaiser

ST. LOUIS, Oct 11 (Reuters) - There may not be as much slack in the U.S. economy as many forecasters believe, which means medium-term inflation risks could be higher, a Federal Reserve official said on Sunday.

In a presentation to an economics conference, St. Louis Federal Reserve President James Bullard said it was hard to accurately measure the gap between what the economy is producing and its full potential.

"I am concerned about a popular narrative in use today -- the narrative being that the output gap must be large since the recession is so severe," he said. "And so, any medium-term inflation threat is negligible, even in the face of extraordinarily accommodative monetary policy. I think this narrative overplays the output gap story."

He said calculations aimed at measuring the output gap do not take asset price bubbles into consideration, so if much of the current drop in output was tied to the bursting of the housing bubble, "then today's output gap would be smaller than it appears," which would mean a higher risk of inflation.

Inflation forecasts vary widely among private economists and even among Fed officials, which has opened up much debate over when the central bank will raise interest rates.

Some argue that with unemployment near 10 percent and idle factory space just off a record high, there is sufficient slack to keep inflation well below the Fed's perceived comfort zone. That would allow the Fed to keep rates low for longer.

But others worry that the Fed's special lending and asset purchase programs, which have more than doubled its balance sheet since the financial crisis intensified in 2008, are sowing the seeds for a serious bout of inflation.

Bullard said that in the past two recessions, which ended in 1991 and 2001, the Fed didn't raise rates until 2.5 to 3 years after the slump ended. If it followed that pattern this time, that could put the first rate hike in 2012.

However, Bullard said the argument that the Fed had kept rates too low for too long earlier in this decade, thereby contributing to the housing boom and bust, "may weigh heavily" on the Fed's policy-setting committee this time.

He said economic growth in the range of 2.5 percent to 3 percent next year was "reasonable" although he cautioned that the labor market will probably remain weak for a while.

EXPANDING BALANCE SHEET

Bullard also said the Fed's $1.75 trillion asset purchase program was adding to uncertainty in financial markets because it was unclear how the central bank might adjust it as economic conditions change.

He proposed establishing something akin to the Taylor rule, which calculates the ideal interest rate for a given set of economic conditions, for asset purchases so financial markets would have a clearer sense of policy direction.

"Good policy means that the Fed needs to communicate to the private sector how it intends to react to shocks in the future," Bullard said.