Feb. 5 (Bloomberg) -- Federal Reserve Bank of St. Louis President James Bullard said the U.S. may experience short-term deflation and that such a development might exacerbate the housing crisis.

“I am worried about deflation,” Bullard said today to a meeting of financial analysts in Clayton, Missouri. “Unexpected deflation would worsen the situation in our housing and mortgage markets.”

The Fed this week extended its emergency-lending programs by six months through Oct. 30, citing “continuing substantial strains in many financial markets.” The Federal Open Market Committee left the benchmark interest rate as low as zero on Jan. 28 and said it’s prepared to buy Treasury securities to revive lending.

Such purchases would extend the Fed strategy of using its balance sheet to reduce borrowing costs. The new program may benefit several types of borrowers, because long-term government bond yields influence interest rates on mortgages, corporate bonds and municipal debt.

The Fed will keep the main interest rate at as low as zero “for the foreseeable future,” Bullard said. Still, he said investors shouldn’t conclude from that that the Fed is “on the sidelines” because policy makers have turned to “innovative, unconventional” measures.

Deflation Risk

Bullard, 47, expanded on his deflation comments after the speech, telling reporters he sees a “downside risk on inflation” with the recession likely to persist until the third quarter.

“You could end up in negative territory” on prices, he said. “I am worried about it, partly because of the global nature of this recession and I think we are not going to get any good news into the fall of this year. That is going to continue to put downward pressure on prices for a period. Policies have to be designed to avoid that outcome.”

Bullard said the current quarter could prove to be the low mark for the recession, while adding the October-through-December period may be revised downward.

The U.S. economy shrank at a 3.8 percent rate in the fourth quarter, the most since 1982. Central bank officials and private economists predict the contraction will continue at least through the middle of this year.

Possible ‘Bounceback’

“If it is like past recessions, even severe ones, you would get a bounceback at some point,” Bullard told reporters. “You would get some impact from the stimulus package. You would expect the consumer to at least flatten out, or possibly increase at some point. You would expect other aggressive policies we have undertaken to have some impact.”

The Labor Department may report tomorrow that the economy lost 540,000 jobs in January and the unemployment rate jumped to a 16-year high of 7.5 percent, according to median forecasts in a Bloomberg News survey. The U.S. lost almost 2.6 million jobs in 2008, the most since 1945.

Companies from Macy’s Inc. to PNC Financial Services Group Inc. have announced job cuts as consumers and businesses rein in spending.

Bullard said the Treasury’s Troubled Asset Relief Program needs to be directed at helping to resolve issues with bad assets held by banks, which he called a precondition to financial markets and the economy improving.

“You have to face the problems directly in financial markets, do our best to get those fixed, before we can get back to a growing economy,” he said.

He also said housing prices are now near “fair value” and therefore unlikely to fall much further. “I think the bubble component is out of housing prices,” though markets can sometimes ”overshoot” on the downside.

Bullard took over as president from William Poole, who retired on March 31. While he won’t vote on interest rates this year at the Federal Open Market Committee, 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: February 5, 2009 16:14 EST