It has only been a few days since the Federal Reserve adopted a formal goal for inflation, and already policymakers are missing their target.

The U.S. central bank's preferred measure of inflation sank to its lowest level in more than a year in the fourth quarter, data showed on Friday.

Growth in the government's personal consumption expenditure index, which the Fed now targets at 2.0 percent, dropped to a 0.7 percent annual rate, about a third of its pace during the previous three months.

Of course, the Fed aims to hit its target over the longer run and will be willing to look through often volatile food and energy prices.

But even stripping those costs out, the inflation rate fell sharply to 1.1 percent over the past three months, a potentially troubling sign that the trend is not the Fed's friend.

With unemployment still at an elevated 8.5 percent, Friday's data could buttress the case within the central bank for taking new action to boost the economy.

Clearly, much work remains to achieve the Fed's dual mandate of maximum sustainable employment in the context of price stability, said New York Fed President William Dudley, who has hinted he supports doing more to lower borrowing costs.

Inflation has retreated and may be headed down further, Dudley told reporters on Friday.

PRIMING THE MONEY PUMP

The Fed's policy-setting committee is divided between officials who want to pump more money into the economy and others known as hawks who worry inflation could get out of hand.

Currently, many investors think the Fed will try to lower borrowing costs further this year through quantitative easing, which entails purchasing securities on the market in order to bring down interest rates for mortgages and business loans.

Economists at 12 of 18 primary dealers, the large financial institutions that do business directly with the Fed, said the central bank would do further quantitative easing, a Reuters poll showed. The poll was conducted after Federal Reserve Chairman Ben Bernanke's news conference on Wednesday.

If that happens, this would amount to QE3 or the Fed's third round of quantitative easing since November 2008 when its first QE program was launched about two months after Lehman Brothers collapsed, during the depths of the financial crisis.

The inflation reading very much supports the idea from the non-hawkish core of the committee that inflation has a downward trajectory right now, said Michael Hanson, an economist at Bank of America Merrill Lynch.

Still, some temporary factors likely pushed inflation numbers lower during the fourth quarter, which could keep officials from rushing into more monetary stimulus.

Prices for durable goods fell at a 2.7 percent annual rate, which analysts attributed to automakers recovering from supply- chain disruptions created by an earthquake in Japan in March.

That suggests while inflation is well below the Fed's target, the economy does not appear poised to slip into deflation, a debilitating spiral of falling prices and wages. Fears of deflation were a major justification for a $600 billion quantitative easing program in late 2010.

This isn't really deflationary, Paul Ashworth, economist at Capital Economics in Toronto, said of the price data.

Nonetheless, the sharp easing in inflation potentially gives the Fed more room to ramp up efforts to boost employment. The PCE price index will likely rise just 1.4 percent this year, said Jeff Greenberg, an economist at Nomura in New York.

The jobless rate, however, remains several percentage points higher than where most Fed officials would prefer it to be, even though it has fallen in recent months. In December, it stood at 8.5 percent.

With this in mind, both Greenberg and Ashworth expect the Fed will launch a new bond-buying program by mid-year.

One factor that could force policymakers to spring to action more quickly is a possible worsening of Europe's banking crisis, which could drag large U.S. financial institutions into a rut and trigger a new credit crunch.

Argued Hanson of BofA-Merrill: That's the wild card and that would potentially change the way the Fed reacts.

(Editing by Jan Paschal)

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