Debts & Loans

A senior Federal Reserve official said on Wednesday purchases of government debt might be useful to spur economic growth or halt a deflationary spiral when interest rates are low, while a Fed survey showed the U.S. economy taking a turn for the worse.

"At times it is necessary to prevent deflation ... you also do it to stimulate the economy when further reductions in interest rates are infeasible," Richmond Federal Reserve President Jeffrey Lacker told reporters after giving a speech to the Chamber of Commerce.
Lacker, nevertheless, said he sees the risk of sustained deflation as small.

With limited scope for further interest rate cuts from current levels of 1 percent, economists expect the Fed to use unconventional measures to boost the supply and circulation of money to avoid a deflationary slump and pull the economy out of its downturn.

Fed Chairman Ben Bernanke said this week the central bank could directly buy U.S. Treasury and government-sponsored agency debt to stimulate growth by holding down yields. The issue is expected to be debated at the Fed's next scheduled policy meeting, on Dec. 15-16.

"That is in essence what those quantitative measures would amount to: monetizing debt," said Lacker, who will be a voter next year on the Fed's interest rate-setting committee.

"As a result, we have to be very careful about it; we have to be careful about withdrawing it before it sparks a run-up in inflation," he said.
The Fed's Beige Book, an anecdotal summary of economic conditions based on the central bank's extensive business contacts across the country, showed that the economy, which this week was formally declared to have been in recession since December 2007, had deteriorated in recent weeks.
Stocks fell as the report added to anxiety about the economic outlook but later rebounded near the closing bell.

The Fed is expected to its lower benchmark interest rate target by a half-percentage point to 0.5 percent at its December meeting.

Some analysts expect the Fed could bring rates down to zero by its following meeting at the end of January as it seeks to reverse the economic contraction linked to the collapse of housing markets and a jump in home loan defaults.

Similarly, central banks in the euro zone and elsewhere are expected to cut borrowing costs aggressively in coming days as fears of a global recession took hold.

In the first such move, New Zealand's central bank slashed interest rates by a record 150 basis points on Thursday and said it may cut further to protect the economy.

The Fed's Beige Book said many regions had reported accelerating layoffs, while wage pressures were largely subdued. Retail sales narrowed and vehicle sales fell off sharply in most regions of the country. The report was based on data collected before Nov. 24.

Some economists fear the U.S. recession risks turning into a Japanese-style 1990s deflation, but Richmond Fed's Lacker said he felt the risk of a sustained deflation was small.

"I see the risk of inflation expectations falling significantly as very minor and that is what it would take for us to get into a sustained deflation," he said.

Other Fed officials have also played down the threat of sustained deflation taking hold. Philadelphia Fed President Charles Plosser said on Tuesday the Fed could ward off any risk of deflation by committing to prevent any broad drop in prices, perhaps with an inflation target.

In Japan, falling prices made the 1990s downturn worse because assets dropped in value relative to the loans with which they were purchased, causing soaring defaults and bank failures.

U.S. consumer prices fell by a record amount in October, largely on declines in energy costs. Although consumer prices are expected to fall further on continued drops in oil prices from record levels in July, officials do not expect an ongoing drop in prices that would trigger a sustained deflation.

Lacker warned that the Fed should not ignore inflation risks as it takes steps to get growth back on track.

He also voiced concern about the emergency liquidity steps the Fed has already taken, which have doubled the size of its balance sheet to around $2 trillion in recent months.

"The dramatic recent expansion in Federal Reserve lending, and government support more broadly, has extended public sector support beyond existing supervisory reach, and thus could destabilize the financial system, if no corrective action is taken," he said.