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FED FOCUS-New phase of crisis revives US deflation concerns

WASHINGTON, May 19 (Reuters) - Ben Bernanke is again being confronted with hints that his sworn enemy, deflation, might be making a comeback. This time though, the Fed chairman’s policy arsenal looks sorely depleted.

Nearly eight years after declaring war on deflation in a speech that earned him the nickname “Helicopter Ben,” the head of the U.S. Federal Reserve is again confronting the threat of a corrosive cycle of falling prices.

One of the U.S. central bank’s favored inflation measures, the core consumer price index, rose just 0.9 percent in the year to April, the smallest gain since 1966. Most Fed officials would like to see that number closer to 2 percent.

“The recent trend in inflation has been swiftly to the downside,” said Eric Green, chief U.S. rates strategist at TD Securities in New York. “All measures of inflation are decelerating.”

In 2002, Bernanke made a vehement case that central banks were not powerless to stimulate the economy even when official interest rates were pushed near zero. The financial crisis forced him to put those ideas into action.

But the unorthodox measures the Fed has taken have come at a high cost, including greater political interference with monetary affairs and, ironically, heightened inflation fears due to the sharp increase in the money supply.

As part of its emergency efforts, the Fed not only slashed interest rates near zero but also bought about $1.7 trillion of mortgage and Treasury bonds, expanding total outstanding credit to the banking system to more than $2.3 trillion.

Having acted so aggressively, the Fed’s room for further maneuver if needed is constrained.

BY WORD AND SWORD

Of course, a single month’s decline does not a trend make. Part of the easing inflation trend has been driven by a decrease in housing costs that is expected to bottom out in the next few months as the downtrodden sector stabilizes.

Yet a sharp recent retreat in commodity prices, which has seen oil prices plunge some $20 in just three weeks to around $68, suggests the disinflation trend is likely to persist.

Market barometers show the concerns gaining ground among investors. On Thursday, the differential between yields on benchmark U.S. Treasury notes and inflation-protected debt fell to its lowest since October, indicating many see deflation as a real possibility.

And with Europe mired in a worsening debt crisis that threatens a flashback to the credit-impaired days of late 2008, the possibility of an unwelcome decline in prices begs the question of what Fed officials might do if deflation sets in.

Deflation, a broad and persistent drop in prices throughout the economy, can eat away at an economy by encouraging consumers to defer purchases and raising the inflation-adjusted burden of debts, fueling further economic weakness in a self-feeding downward spiral.

“What is going on in Greece, and the Club Med countries in general, must be seen as a significant deflationary shock -- underscored by the fact that U.S. dollars are in such huge demand as was the case after the Lehman collapse,” said David Rosenberg, chief economist at Gluskin Sheff.

EMPTIER TOOLKIT

In his 2002 speech, entitled “Deflation: Making Sure It Doesn’t Happen Here,” Bernanke outlined what the Fed could do if faced with a deflationary .

But the Fed has already put into play a number of the ideas Bernanke discussed, including buying up government and private debts and committing to holding short-term rates low for a long time to pull down long-term borrowing costs.

Now, its room for maneuver is limited. The Fed’s relatively modest purchase of $300 billion in longer-term Treasury securities sparked fears the central bank was “monetizing” government deficits by printing money.

Another possible approach would be to actively raise the Fed’s implied inflation target of about 1.5 percent to 2 percent. This has been advocated by some prominent economists, but does not hold great favor among members of the Fed’s Washington-based board, who fear such a move could unleash an inflation that might be hard to stop.

John Canally, economist for LPL Financial, said that while inflation expectations, which the Fed sees as a harbinger of inflation itself, are relatively stable, anxiety is showing up in certain places. Just look at the price of gold, he says. The price of the yellow metal, seen as an inflation hedge, has continued to hit new records despite the prospect of renewed economic weakness. (Reporting by Pedro Nicolaci da Costa; Editing by Kenneth Barry)

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