Nov. 20 (Bloomberg) -- The Federal Reserve has limited room to cut its target interest rate and may shift the focus of monetary policy more to increasing liquidity, said James Bullard, president of the Federal Reserve Bank of St. Louis.

``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,'' Bullard said today in a speech in Evansville, Indiana.

Fed policy makers, according to minutes of their meeting released yesterday, marked down their forecasts last month for growth and inflation while cutting the benchmark interest rate to 1 percent to avert the worst economic slump since World War II. The central bank has supplemented the rate reductions by creating emergency lending programs and expanding its balance sheet to more than $2 trillion from $1.32 trillion a year ago.

Policy makers predicted the U.S. economy will shrink until the middle of next year, with some members of the Federal Open Market Committee voicing concern about the risks of deflation, while indicating openness to further cuts, according to minutes of the Oct. 28-29 meeting.

``Whether the FOMC 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,'' Bullard said at a regional economic conference. ``The fact is, monetary policy defined as movements in short-term nominal interest rates is coming to an end, at least for now.''

Consumer prices excluding food and fuel costs fell last month for the first time since 1982, according to government figures. The consumer price index plunged 1 percent in October, the most since records began in 1947, the Labor Department said.

Deflation `Challenging'

``Deflation, should it occur in the U.S., might be particularly challenging because some of the core problems we have are in housing markets, where contracts are written in nominal terms,'' Bullard said. ``One idea from the Japanese experience is that, with nominal interest rates at very low levels, more attention may have to be paid to quantitative measures of monetary policy.''

The Bank of Japan held the key interest rate at zero from 2001 to 2006 and flooded the banking system with extra cash to encourage lending, spur growth and overcome deflation.

Bank of Japan Governor Masaaki Shirakawa, who helped implement the policy as a BOJ official, said in May that it had ``only a limited impact'' in propping up growth.

Abundant Funds

Abundant funds pumped into the market failed to persuade commercial banks to lend to businesses and consumers. Instead, cash sat in lenders' accounts at the central bank, causing their reserves to swell almost nine times to 35 trillion yen ($368 billion) by early 2004. Meanwhile, daily call market trading volume dwindled to around 5 trillion yen from 20 trillion yen.

Fed Vice Chairman Donald Kohn said yesterday the central bank, while simultaneously reducing interest rates and expanding its balance sheet, isn't adopting one strategy ``in favor of another.''

``We are lowering interest rates, lowering our target rate, and at the same time engaging in a great amount of liquidity provision to the system,'' Kohn said in response to a question at the Cato Institute's annual monetary conference in Washington.

``It would take some doing to get some deflation,'' Bullard told reporters after the speech. ``Inflation expectations are very fluid right now and that is one of the prime determinants of what is going to happen.''

Bullard said the economy was currently contracting and would shrink through at least the first quarter. It was too soon to say that the downturn would be unusually severe, he said.

`Fall Sharply'

``To be sure, current quarter output is expected to fall sharply, followed by further but less-severe contraction in the first quarter of 2009,'' Bullard said. ``If that scenario materializes, the contour of the current recession will look much the same as that of the 1990-91 recession.''

``You've got a very pessimistic consumer and consumption is going down now and is going to be a drag on the economy,'' Bullard said in response to an audience question.

Bullard took over as president from William Poole, who retired on March 31. He had been in the St. Louis Fed's research department for more than 18 years. He won't vote this year on interest rates on the Federal Open Market Committee and his turn in the rotation among Fed bank presidents will be in 2010.

To contact the reporters on this story: Steve Matthews in Atlanta at smatthews@bloomberg.net;

Last Updated: November 20, 2008 22:25 EST