Fed officials play down risk of deflation

ROCHESTER, New York (Reuters) - The United States does not face a high risk of Japan-style deflation and ought to spell out a target for prices to keep this threat at bay, two top Federal Reserve policy-makers said on Tuesday.

With the United States already in recession for a year after the collapse of its housing market, many economists fear it could suffer the sustained decline in prices that inflicted a decade of stagnation in the Japan during the 1990s.

Philadelphia Federal Bank Reserve President Charles Plosser, a noted inflation hawk who has voted against rate cuts twice this year, noted that tumbling energy prices had dragged down the headline measure of the U.S. consumer price index.

“This has prompted some commentators to suggest that the U.S. is facing a threat of sustained deflation, as we did in the Great Depression or as Japan faced for a decade. I do not believe this is a serious threat,” he told an economic seminar at the University of Rochester Business school.

In Japan, falling prices after a property and stock market bubble burst made its economic downturn worse because assets dropped in value relative to the loans with which they were purchased, causing loan defaults and bank failures to soar.

St Louis Federal Reserve President James Bullard, another anti-inflation hawk, separately made a similar point.

“Look at PCE (personal consumption expenditures) inflation measured from one year earlier. It smoothes out some of the fluctuations. It is still over two percent. It would take a lot to drag that down to a deflationary level,” he told Bloomberg Television in an interview.

“So I don’t think the risk is that high right now. I do think that the inflation expectations are very fluid right now. The big challenge for the Fed is to keep these under control and keep people reassured that we are intending to stay near target,” said Bullard, who is not a voting member of the Fed’s interest rate-setting committee this year.

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Fed Chairman Ben Bernanke is a long-standing advocate of inflation targeting, but was unable to persuade enough Fed colleagues of its merits when this topic was debated after he took over at the helm of the U.S. central bank in 2006.

Plosser made clear he felt an inflation target would help the Fed communicate its monetary policy and keep deflation risks under wraps.

“As long as inflation expectations remain well anchored, these declines in energy prices are unlikely to lead to sustained deflation any more than their previous increases were likely to lead to sustained inflation,” said Plosser.

The Fed has slashed interest rates by 4.25 percentage points to 1 percent to contain the housing fallout and is expected to cut by another half point at its next scheduled meeting, on December 15-16, and maybe go to zero in January.

Bullard made clear that he was not convinced by arguments for further rate reductions.

“Fed funds is trading pretty low right now. I have not been a fan of going to really low levels,” he said, noting that when the Fed held rates at 3 percent during the 1990-91 recession, the outcome had been good for growth, jobs and employment

“In the 2001-2003 episode we went all the way down to 1 percent. Some have said that that created problems. So I think those two episodes: stopped at three, stopped at one. Why not stop at one this time? Why is it zero this time? I don’t quite get that,” he said.

Answering reporters’ questions after his speech, Plosser said the Fed will face difficult decisions as interest rates go lower, including about how quantitative easing would work.

If the Fed were to embark upon a regime of quantitative easing, using unconventional measures to boost the supply and circulation of money alongside conventional rate policy, he said it could buy a range of securities to expand its balance sheet, not just U.S. Treasuries or shorter-term securities.

Asked if the Fed was already quantitatively easing, Plosser said it was “not unreasonable” to describe the Fed’s recent balance sheet expansion as “a form of quantitative easing.”

Writing by Alister Bull; Editing by James Dalgleish