March 28 (Bloomberg) -- The Federal Reserve is probably considering its policy options should a shock to the economy force it to cut interest rates to zero, according to ABN Amro Holding NV.

Fed Chairman Ben S. Bernanke wrote a paper in 2004 with Vincent Reinhart and Brian Sack studying Japan's experience with deflation, a period where the Bank of Japan added more funds to the financial system even when its benchmark interest rate was at zero. The ``most obvious lesson'' is that central banks should avoid an outbreak of deflation and accept an inflation buffer, Robert Lind, ABN Amro's chief economist in London, wrote in a report.

``Senior officials have already laid out the potential policy choices,'' according to Lind at the Amsterdam-based bank. ``Given the scale of the potential shock to aggregate demand, I suspect policy makers are already contemplating the constraint of the zero bound.''

The central bank has slashed the target for the overnight lending rate between banks by 2 percentage points this year to 2.25 percent, the most aggressive easing in two decades. Futures traders in Chicago have added to bets this month that policy makers will need to cut rates to as low as 1.25 percent by December to support the economy as the nation faces an end to its six-year expansion.

The economy grew at an annual pace of 0.6 percent from October though December, weakened by a housing slump and losses on subprime-related debt. The world's biggest financial firms have reported more than $208 billion in asset writedowns and credit losses linked to the securities since the start of 2007.

Three Options

The Fed would have three options to continue supporting the economy should it lower interest rates to zero, wrote Lind, citing Bernanke's 2004 report, written while he was a Fed governor.

The central bank could use dialogue to influence expectations about future monetary policy, akin to the ``considerable period'' language that was introduced in 2003 to stimulate the economy when interest rates were at 1 percent, according to Lind. Policy makers might also add more funds to the financial system or purchase bonds to reduce long-term rates, Lind wrote.

The odds of rate reductions to 1.25 percent by the end of this year rose to 4 percent from almost zero a month ago, futures on the Chicago Board of Trade show. The most likely scenario with a 42 percent chance is a decrease in the Fed's benchmark to 1.75 percent, according to the contracts.

To contact the reporter on this story: Oliver Biggadike in Tokyo at obiggadike@bloomberg.net.

Last Updated: March 28, 2008 00:31 EDT