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Fed's Kohn: Contraction ahead, deflation risk rises

WASHINGTON (Reuters) - The U.S. economy is likely to shrink for at least half a year and the Fed should act aggressively against any risks that deflation could take hold, Federal Reserve Vice Chairman Donald Kohn said on Wednesday.

“We have a very weak economy. The U.S. economy is declining right now,” he said in response to questions after a speech at the Cato Institute.

“My most likely outcome is for a couple of quarters of negative growth, and inflation coming down, but not getting to that deflationary state,” he added.

Kohn said that while risks of deflation are small, they had risen in recent months and that policy-makers should be vigilant to ensure the phenomenon does not become sustained.

Government data released on Wednesday showed U.S. consumer prices fell by 1 percent in October, the fastest rate since the Commerce Department began collecting data in 1947, raising deflation worries.

Japan’s economy stagnated for roughly a decade in the 1990s as deflation launched a vicious cycle of dwindling spending and investment and contracting economic activity.

The Fed should learn from Japan’s experience and be aggressive in getting ahead of any risks from deflation, Kohn said.

“Some people have argued that we should save our ammunition, that interest rate cuts aren’t effective,” he said. “I think that were we to see this possibility, that we should be very aggressive with our monetary policy, as aggressive as we can be.”

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The Fed has already cut interest rates by 4.25 percentage points to 1 percent in 2008 to combat the credit crisis and support the faltering economy.

Kohn said the U.S. central bank should consider forms of “quantitative easing,” the effective lowering of interest rates by flooding markets with funds.

“We have already engaged in forms of quantitative easing and we should be looking carefully at the effects that they might have, what other forms of quantitative easing might happen as a contingency plan, should that still remote possibility -- but I think less remote than it was -- occur.”

Kohn told the conference shakiness in the economy and in the financial system is likely to continue for an extended period and that regulation, not rate rises, was the most effective prevention against a repeat of the rapid expansion and painful collapse of the housing market.

“Although the outlook remains extremely uncertain, both the fragility of the financial system and the weakness in real activity seem likely to persist for a while,” Kohn said.

Kohn said the economic mess that began with risky lending and questionable financial market practices in the United States would take longer to clear up than past shocks because of the size of the problem, the key role housing plays, and the extent to which banks have been exposed to losses.

“The economic disruption here and abroad is likely to be considerably more severe than in past episodes,” he said.

In spite of the serious damage done by the bursting of the housing bubble and its aftermath, Kohn said he remains skeptical that central banks can anticipate and prevent asset price bubbles by raising interest rates, adding:

“I am not convinced that the events of the past few years and the current crisis demonstrate that central banks should switch to trying to check speculative activity through tighter monetary policy whenever they perceive a bubble forming.”

Rather than using the blunt tool of adjusting interest rates, policy-makers should examine more careful use of regulation and supervision to address concerns about potentially dangerous behavior, he said.

Editing by James Dalgleish

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