Fed says it’s ready to take action to avert deflation

The Federal Reserve for the first time raised direct concern that the nation’s economy may be headed into a deflation trap and expressed new readiness to take more action to avert a serious turn for the worse.

In a statement issued Tuesday after its seventh policy-setting meeting of the year, the central bank noted once more that the pace of economic recovery and employment growth have slowed in recent months. But this time the Fed made clear it was also worried about another potential problem: a downward spiral of prices that could undermine wages, hiring and overall economic activity.

Such a spiral is difficult to reverse, as Japan discovered during its “Lost Decade” of economic stagnation in the 1990s. Japan has still not regained the level of economic vigor that made it one of the world’s strongest economies.

Besides the threat of deflation, the Fed is looking at an economy that isn’t growing fast enough to bring down the high rate of unemployment, currently at 9.6% and expected to edge higher in the coming months.

A core measure of consumer prices, excluding volatile energy and food costs, has been running at a little less than 1% in the United States. While that may be a good thing for consumers on a day-to-day basis, it is less than the 1.5% to 2% that Fed policymakers aim for in order to steer a course between inflation and deflation.

Tuesday’s statement acknowledged that underlying inflation measures are “somewhat below” the Fed’s comfort zone.

“It’s an indication that the Fed is concerned we’re getting closer to deflation,” said Lyle Gramley, a former Fed governor who is a senior economic consultant at the Potomac Research Group.

Financial markets read a shift in the Fed’s statement on inflation as a sign that the central bank soon could launch a huge new round of “quantitative easing” — meaning a massive program of Treasury bond purchases, perhaps totaling upward of $1 trillion.

The goal would be to pull longer-term interest rates lower, pump up the supply of money in the financial system and, the Fed would hope, eventually boost inflation.

Any move to flood the system with more dollars would be expected to drive down the greenback’s value, improving the prospects for American exports but raising the potential for inflation.

On Tuesday, stocks shot up immediately after the Fed’s announcement but then fell back, with the Dow closing up 7 points to 10,761. The dollar slumped, as did the yield on the 10-year Treasury note, a benchmark for mortgage rates and other long-term rates.

The bank already has bought $1.75 trillion of government bonds and mortgage debt, and after its meeting on Aug. 10, the Fed said it would reinvest maturing securities in Treasury bonds — maintaining the size of its bloated portfolio — and “will employ its policy tools as necessary to promote economic recovery and price stability.”

The Fed was more explicit in Tuesday’s statement, saying it was “prepared to provide additional accommodation if needed.”

To Chris Rupkey, chief financial economist at the Bank of Tokyo-Mitsubishi in New York, that’s code for gearing up to pump more money into the nation’s economic bloodstream, with an announcement coming as soon as the Fed’s next meeting, in early November.

“I think they’re halfway to easing” monetary policy, he said.

The Fed would be prone to take action if economic indicators in the coming several weeks continue to be disappointing. Although the recession that started in December 2007 was officially declared over in June 2009, economic growth has slowed sharply since spring. Most analysts see gross domestic product in the current third quarter growing at a measly 1.5% annual pace.

Conversely, Fed officials could back off from further monetary easing if the economic statistics turn more positive. The most recent data on unemployment insurance claims and retail sales were better than expected, but the Fed’s statement made no mention of those data.

On Tuesday, there was also some encouraging news on the housing front as the government reported that construction of newly built homes jumped a surprising 10.5% in August from July, although most of the increase came from the volatile sector of apartment buildings and condominiums.

Sales and construction of single-family homes have struggled in recent months with the expiration of a popular tax credit for buyers, and most economists predict weakness for housing this year. But the increase in new starts stirred modest optimism that the worst of the sales decline might be abating.

“It is reasonable to believe, in our view, that the post-tax-credit plunge in housing activity, both sales and construction, is over, but we do not expect to see a strong recovery anytime soon,” said Ian Shepherdson, chief U.S. economist for High Frequency Economics. “Activity will likely creep higher as great affordability pulls people into the market, but that’s about the best we can hope for in the foreseeable future.”

Other analysts pointed out that housing-start statistics are highly volatile. The number of issued housing permits, a more stable measure of homebuilding activity, increased by a much more modest 1.8% in August, with single-family home permit counts down 1.2%.

don.lee@latimes.com

Times staff writer Tom Petruno in Los Angeles contributed to this report.