(Updates with Bullard remarks during Q&A sessions)
By Alister Bull
EVANSVILLE, Ind., Nov 20 (Reuters) - Deflation would be very damaging to the United States economy and with nominal interest rates already very low, quantitative easing may be needed to keep it at bay, a top Federal Reserve official said on Thursday.
"At least over the near term, any additional influence through interest rate reductions will be limited and the focus of monetary policy may turn to quantity measures," St Louis Federal Reserve President James Bullard told a regional economic conference.
Quantitative easing recalls the massive liquidity injections made by the Bank of Japan during the 1990s to re-inflate growth once official interest rates reached zero.
Some economists believe the Fed will cut rates to zero over the next three months, together with actions to boost the money supply, as the U.S. central bank takes aggressive steps to prevent the world's biggest economy from Japanese-style deflation and lost decade of growth.
Bullard stressed he saw deflation, which is a broad decline in prices, as a remote risk in the United States, but one that deserved to be taken seriously.
"It would take some doing to get some deflation. But what I do think is the inflation expectations are very fluid right now, and that is one of the primary determinants of what is going to happen," he told reporters after the speech.
"If we do our job it won't happen and we're dedicated to that," he said.
U.S. consumer prices fell by 1.0 percent in October and the year-over-year change slowed to 3.7 percent from a peak of 5.6 percent in July, as weakening global growth sent energy and other commodity prices tumbling.
VOLATILE COMMODITIES
Some economists expect negative annual inflation rates in 2009 and say the risk of a widespread deflation has increased as the United States, Japan and Europe are set to suffer simultaneous recession next year for the first time since World War Two.
But Bullard played down such a threat by noting the core level of inflation, which excludes energy and food prices, was still above 2 percent and some way from deflationary territory.
"The (Federal Open Market) committee has focused mostly on core measures of inflation. We know that commodity prices are extremely volatile and we've seen that extreme volatility right during the fall," he told reporters.
In the speech, Bullard noted Fed rates have already been cut to 1 percent in response to financial crisis caused by the collapse of the U.S. housing market "with further easing possible as weak data roll in over the next several months."
But he downplayed the importance of further changes in the Fed's overnight funds rate.
"Whether the FOMC (Federal Open Market Committee) decides to stay on hold at this point or eases further and then stays on hold at some lower level, even zero, may not be the most critical question.
"The fact is, monetary policy defined as movements in short-term nominal interest rates is coming to an end, at least for now," he said in the speech.
Bullard, who is not a voting member of the Fed's interest rate-setting committee this year, said U.S. deflation would be particularly bad since housing is at the core of the current credit crisis and housing contracts are set in nominal rather than inflation-adjusted terms.
"An unexpected deflation would make these contracts more expensive for borrowers," he said.
The Fed has slashed its target for the funds rate by 4.25 percentage points to 1 percent since September 2007.
But since the failure of investment bank Lehman Brothers in September banks have sat on their amassed liquidity and refused to lend to each other despite low Fed rates.
This had led to speculation about what innovation the Fed might deploy to get banks to lend and to prevent deflation - defined as a general decrease in prices - from taking hold.
"By announcing and maintaining targets for key monetary quantities, the Fed may be able to keep inflation and inflation expectations near target and ward off either a drift toward deflation or excessively high inflation," Bullard said.
"This will be an important issue for the Fed in coming months and represents a challenge in the communication of monetary policy going forward," he said. (Editing by Tomasz Janowski)