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SAN FRANCISCO (Reuters) - Setting an explicit inflation target would help the U.S. Federal Reserve keep deflation at bay now that interest rates have been cut to almost zero, a top central banker said on Saturday.
"Now would be a particularly good time to do that because you have this possibility of expectations drifting off to deflation or a lot of inflation," James Bullard, president of the St Louis Federal Reserve Bank, told a panel discussion during the annual meeting of the American Economics Association.
Deflation, a sustained period of widespread falling prices, is considered a threat to the economy because it can cause consumers to delay purchases on expectations that prices will fall further, causing the economy to contract.
Bullard said that the Fed is limited in its ability to flag policy preferences by the very low level of rates and needs to find another tool to communicate with markets.
"You can't count on your nominal interest movements to signal to the private sector about how you are reacting to events. So my main concern for the Fed in the medium term...is how to keep inflation expectations anchored. ... We can no longer send signals by moving interest rates," he said.
Fed Chairman Ben Bernanke is a long-standing advocate of adopting an explicit inflation target, but he put this goal on hold after failing to convince other policy-makers that it was worth the loss in flexibility.
Bullard said aggressive Fed policy action to restore growth means the U.S. central bank has a real opportunity to introduce the target at a time when communication is extremely tough.
The Fed last month cut its overnight funds rate target to a range between zero and 0.25 percent and said it would focus on unconventional tools to end the year-long U.S. recession.
Charles Evans, president of the Chicago Fed, told the panel that the action had been aimed at driving the funds rate below zero.
"If it were not constrained by zero those (economic) models would want to push it below zero, but that's not possible," Evans told reporters, adding quantitative measures "is a way to mimic below-zero rates and provide support to the economy."
These actions have massively expanded the size of the Fed's balance sheet as it has sought to stimulate U.S. domestic demand by targeting specific sectors of the economy like the housing market, whose collapse last year sparked the recession.
Some economists expect U.S. growth to have contracted by 6 percent or more on an annual basis in the final quarter of 2008 and will continue shrinking until the second half of 2009.
Evans said the U.S. jobless rate appears on pace to exceed 8 percent in 2009, from the most recent reading of 6.7 percent in November. Private sector economists are even gloomier.
This reversal has led to a collapse in commodity prices, dragging down the rate of headline inflation and raising fears the United States could suffer the same fate as Japan's so-called lost decade after the collapse of its property market at the end of the 1980s.
Those years of stagnation were made worse by deflation, which caused domestic economic activity to contract even more.
Bullard said such a scenario was not likely in the United States, noting that core U.S. inflation, which excludes food and energy prices, was running around 2 percent compared with a year ago.
He said it would take a lot to push that pace into negative territory, but acknowledged the threat must not be ignored.
"If deflationary expectations were to become entrenched then I think deflation could become a reality. So it is a serious risk that we should be thinking about," he said.
Writing by Alister Bull, editing by Leslie Adler