Feb. 17 (Bloomberg) -- Federal Reserve Bank of St. Louis President James Bullard said the U.S. faces a risk of “sustained deflation” and called on the central bank to avert a decline in prices by expanding the money supply.

The prospect of deflation is a “significant downside risk” and may increase home foreclosures, Bullard said in a speech today in New York. Adopting a target “rapid” growth rate for the monetary base, which includes money in circulation and banks’ reserve deposits with the Fed, should “head off any incipient deflationary threat,” he said.

Bullard is one of a few Fed officials to advocate a new policy tool after the Federal Open Market Committee in December cut its main interest rate almost to zero. The central bank is using money-creation authority to put assets such as home loans on its balance sheet, aiming to unfreeze credit and end the longest recession since 1982.

“By expanding the monetary base at an appropriate rate, the FOMC can signal that it intends to avoid the risk of further deflation and the possibility of a deflation trap,” Bullard said in prepared remarks to the New York Association for Business Economics.

He didn’t propose a specific figure for the target.

The FOMC said in its Jan. 28 statement that there’s “some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.”

Growth Target

The FOMC at its December meeting discussed setting a target for growth in measures of money, such as the monetary base. While a “few” policy makers favored a numerical goal for money growth, most preferred a more open-ended “close cooperation and consultation” with the Fed board on how to expand assets and liabilities, according to minutes of the session.

Bullard’s warning about deflation is stronger than comments by other central bank officials. Chicago Fed President Charles Evans said Feb. 11 that he’s “not tremendously concerned about deflation.”

Bullard told reporters after the speech he supports the adoption of an inflation target to prevent expectations for prices from falling too far. A target for inflation “would be helpful at this time,” he said.

“You have to consult with all players, including Congress,” he said. “If they don’t want to do it, then we don’t do it.”

Rescue Plan

The Fed announced last week that it may expand a program aimed at supporting consumer loans to $1 trillion from $200 billion, aiding Treasury Secretary Timothy Geithner in the government’s revised financial-rescue plan. Separately, the Fed is buying $600 billion of debt sold by government-backed mortgage finance companies and mortgage-backed securities they guarantee.

Other emergency-lending programs that have swelled the Fed’s balance sheet by more than $1 trillion since December 2007, including the Term Auction Facility and commercial-paper backstop, are “temporary” and would fail to meet a goal of combating deflation by increasing the monetary base, Bullard said.

“These programs seem to be a thin reed on which to balance medium-term inflation objectives,” he said. “Outright purchases of agency debt and MBS are likely to be more persistent, however, and it is these purchases that may provide enough expansion in the monetary base to offset the risk of further disinflation and possible deflation.”

Purchasing long-term Treasuries “is still on the table” as a policy option, Bullard said, answering an audience question. The debate over buying Treasuries has continued for two meetings of the FOMC and may continue through the spring, Bullard told reporters.

Increase Credit

“For now we want to see how other” emergency Fed programs designed to increase credit “work out,” he said.

Targeting monetary growth isn’t a sure thing. “One important disadvantage is that the linkages between the growth rate of the monetary base and key macroeconomic variables are not statistically tight,” Bullard said.

Bullard also said he wouldn’t recommend the approach for “normal times,” doing so now only because of near-zero interest rates and the “exceptionally weak state of the economy.”

Congress in the 1970s required the Fed to set monetary targets twice a year and explain any deviations. From 1979 to 1982 central bank officials used money growth targets more to influence the economy.

Shifted Back

For the remainder of the 1980s, the Fed shifted back to a focus on interest rates as the main policy tool. The FOMC stopped setting money supply targets after the legal requirements lapsed in 2000.

Bullard, 47, took over as president from William Poole, who retired on March 31. While he won’t vote on interest rates this year at the FOMC, his turn in the rotation among Fed bank presidents will be in 2010. Bullard was previously the St. Louis Fed’s deputy director of research for monetary analysis.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net; Anthony Massucci in New York at amassucc@bloomberg.net.

Last Updated: February 17, 2009 14:52 EST