U.S. Fed official warns of risk of deflation

A senior U.S. Federal Reserve official on Tuesday warned of risk of deflation, noting deflation in the United States might be particularly pernicious.
"The primary near-term risk for monetary policy is continued disinflation and a possible deflationary trap," James Bullard, president of the Federal Reserve Bank of St. Louis, said in a speech to the New York Association for Business Economics, Xinhua reported.
In the United States, core personal consumption expenditures ( PCE) inflation has been negative during each of the last three months of 2008. The readings for the core consumer price index ( CPI) inflation during these three months were similar, near zero to slightly negative.
"It is reasonable to say that core inflation is running at zero to slightly negative rates at this time," Bullard said.
Further, the global recession promises to carry on at least through the first half of 2009. "This suggests that there is a risk that core prices may continue to stagnate or decline slightly for some time to come," said the president.
"Should lingering financial turmoil continue to weigh on the economy and stretch the recession out still longer, the zero or negative inflation could continue through 2009," Bullard said. " Over that time frame, deflationary expectations could become entrenched."
For this reason, "I think we face some risk -- at this point only a risk -- of sustained deflation."
A widespread and prolonged falling prices can drag down Americans' wages, clobber home and stock prices, and hurt businesses' profits, wreaking more havoc on the ailing economy.
"Ongoing deflation in the United States might be particularly pernicious," Bullard noted.
Household mortgages are long-term nominal contracts. Sustained deflation increases the real debt burden of leveraged homeowners and can erode their equity.
"With sustained deflation, the foreclosure experience that we have seen in the subprime market could generalize to a wider spectrum of homeownership," said Bullard, adding "this is a significant downside risk to macroeconomic performance."
In more ordinary times, central banks would have a standard policy response to inflation rates falling substantially below desired levels: namely, lower the policy rate.
However, the zero bound is constraining that response in the current environment.
The implementation of monetary policy has to be refocused, Bullard said. "The new focus should be on quantitative measures of policy."
In an effort to help the U.S. economy which has been in recession since December 2007, the Federal Reserve has cut a key interest rate to a range of zero to 0.25 percent and is expected to hold it at the record low for the rest of this year.

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