NEW YORK - The Federal Reserve needs a more systematic approach to expanding U.S. money supply to avoid deflation as it combats a global recession that looks likely to last at least through the first half of 2009, a top Fed official said on Tuesday.

A key near-term risk for 2009 is disinflation and possibly deflation, St Louis Federal Reserve Bank President James Bullard said in remarks prepared for delivery to the New York Association for Business Economics.

While the monetary base has expanded at an extraordinary fast pace during the fall and winter, much of that expansion has been closely related to the Fed's lender of last resort function, and cannot be counted on to keep expectations of disinflation and deflation at bay.

Because of this, the Fed needs a more systematic method of keeping the persistent component of monetary base growth rates elevated in order to combat the risk of a deflationary trap.

The U.S. central bank has lowered interest rates almost to zero and pumped hundreds of billions of dollars into financial markets in its efforts to unfreeze credit markets and battle a crippling recession.

I believe it is fair to conclude we are entering an extended period of exceptionally low policy rates globally, said Bullard, who does not have a seat on the Fed's policy-setting committee this year.

In the United States, the setting of nominal interest rate targets as a monetary policy tool will be off the table for some time. Given the extraordinary circumstances, he said, the Fed should provide a credible nominal anchor for the economy.

He said the Fed could set quantitative targets for monetary policy, beginning with the growth rate of the monetary base.

Bullard said he expected U.S. output and employment to continue to shrink in the first half of 2009, adding that the global recession promises to continue at least through that time period. He said it would be reasonable to say core inflation is running at zero to slightly negative rates.

Through a number of unconventional monetary policy measures the Fed has more than doubled its balance sheet to around $2 trillion. Much of the expansion is driven by temporary programs, such as the Term Auction Facility (TAF), Bullard said.

However, some of the programs could be longer lasting, including the Fed's purchases of agency debt and agency mortgage-backed securities, Bullard said. It is also about to launch the Term Asset Backed Securities Loan Program, which will target auto loans, credit cards and student loans.

While the programs may help, we remain far from the systematic approach I would like to see, said Bullard.

(Reporting by Kristina Cooke, Editing by Chizu Nomiyama)

Inflation