Fed warns against risk of deflation

THE FEDERAL Reserve will take every step required to ensure the US does not fall into deflation, its vice-chairman said yesterday, as data showed consumer prices fell a record amount last month.

Donald Kohn, Fed vice-chairman, stressed that he did not believe deflation was the most likely outcome for the US economy, but was a "less remote" possibility than he previously thought. "Some people have argued that we should save our ammunition,that interest-rate cuts aren't effective,'' he said. "I think that were we to see this possibility, that we should be very aggressive with our monetary policy, as aggressive as we can be."

The consumer price index (CPI) data point to more easing in US interest rates. The Fed has cut rates by 4.25 percentage points to 1 per cent in 2008 to combat the credit crisis and support the economy. Yesterday's data highlighted concerns the US economy faced a sustained period of falling prices, or deflation, not seen for at least half a century. Combined with figures showing another big slide in US housing starts, they prompted sharp falls on US and European stock markets.

The CPI fell 1 per cent in October after being unchanged in September. Much of the fall in headline inflation came from energy prices dropping 8.6 per cent. Yesterday, crude oil fell to $53.30 a barrel, its lowest since January 2007.

The main surprise from the CPI report was the slide of 0.1 per cent in the core CPI rate, which excludes food and energy prices. It was the first negative core reading since December 1982.

"The collapse in energy prices means that headline inflation is almost guaranteed to turn negative next year," said Paul Ashworth, senior US economist at Capital Economics. He said the past three months of CPI readings, when calculated as an annual rate, are "already at minus 4 per cent".

The SP 500 traded 3 per cent lower at midday and was on course to close at a new 5½-year low.

"The general thrust of the report supports our call that disinflation is now a reality and deflation will be the next major risk to financial markets," said Steven Ricchiuto, chief economist at Mizuho Securities. "An extended recession will increase the risk of the economy transitioning into an outright deflationary environment." - ( Financial Timesservice)