Disinflation, with the possibility of deflation, is the key near-term risk for the economy, and under these conditions monetary policy should focus “on quantitative measures, beginning with the monetary base, to get some idea of the thrust of policy with respect to inflation,” according to Federal Reserve Bank of St. Louis president James Bullard.

“The monetary base has expanded at an extraordinarily fast pace during the fall and winter, much of that expansion has been closely related to the Fed’s lender-of-last-resort function, and cannot be counted on to keep expectations of disinflation and deflation at bay,” Bullard said. He added that the Fed needs “a more systematic method of keeping the persistent component of monetary-base growth rates elevated in order to combat the risk of a deflationary trap.”

Speaking to the New York Association for Business Economics yesterday, according to prepared remarks released by the Fed, Bullard said, the financial crisis has reached “a broad spectrum of financial markets and institutions around the world.” While the housing market downturn is seen as the starting point, the onset of “a sharp recession” has made the situation worse, he said.

“One danger of the current situation is that ... medium-term inflation expectations of the private sector can begin to drift, possibly toward a deflationary trap,” Bullard said. “In particular, once the zero lower bound is encountered, there is no conventional Fed policy tool — no nominal interest rate move — that will head off inflation that is 'too low’.”

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