I do not believe that deflation is a major risk right now. But deflation can be dangerous because for any given interest rate, it increases the corresponding real (or inflation-adjusted) interest rate, and thus stifles growth. For a sustained deflation to emerge, people have to believe that the money supply will fall along with the price level.  That's what happened during the first three years of the 1930s, at the beginning of the Great Depression, when the U.S. consumer price index fell by 27 percent, and the monetary base shrank by 28 percent. Central banks can prevent deflation by credibly committing to keep the money supply from contracting. Such a commitment is a natural byproduct of a credible commitment to price stability, but for a central bank that has not yet formally adopted an inflation objective, preventing deflation can present additional challenges. This is why some central banks increase the quantity of their monetary liabilities dramatically when interest rates are at zero — to convince the public they will not let the money supply contract in the future.

"The first thing I tell people on deflation is obviously there is always a possibility, but I don't consider it to be a large possibility," Kansas City Federal Reserve President Thomas Hoenig said in response to a question.

As reported by Reuters.

An extensive literature and some recent experience suggest that central bank communications may also play a helpful role in addressing the constraints relating to the zero-bound... [T]he FOMC can work around the zero lower bound on the overnight interest rate by lowering interest rate expectations in the future, thus pushing down longer-term interest rates to stimulate private spending. The Fed employed such an approach between 2003 and 2005, and has taken an important step along the same path in its December announcement by stating that "exceptionally low levels of the federal funds rate" are likely to be warranted "for some time" due to "weak economic conditions." I believe that such statements can play a useful role in more clearly indicating to markets the Committee's own expectations concerning the federal funds rate path, conditional on the Committee's economic forecast.

Communication also can be important in the Fed's efforts to anchor long-term inflation expectations. As I mentioned at the outset, the odds are high that over the next few years, inflation will decline below desirable levels. It is especially important in such circumstances for the Fed to emphasize its commitment to returning inflation over time to the higher levels that are most appropriate to the attainment of its longer-term objectives. A decline in inflationary expectations when economic conditions are weak is pernicious, especially so when the federal funds rate has reached the zero bound, because any downdrift in inflation expectations leads to an updrift in real interest rates and a tightening of financial conditions.

The potential for real interest rates to rise as inflation declines creates a significant downside risk because, with an extended period of abnormally high unemployment in the forecast, it is increasingly likely that inflation will fall to undesirably low levels. This is an additional consideration that, to my mind, militates in favor of strong policy responses.

At a time of great concern about financial turmoil, we should keep in mind that instability in the general level of prices — whether inflation or deflation — is itself a significant source of financial instability. Federal Reserve officials, myself included, have spoken of the importance of keeping inflation expectations well anchored. When the public's inflation expectations begin to rise, that can contribute to higher actual inflation...

It is just as important that inflation expectations remain well anchored in the face of falling energy prices. Significant declines in gasoline and fuel oil prices, for instance, have recently led to declines in the consumer price index. This has prompted some commentators to suggest that the U.S. is facing a threat of sustained deflation, as we did in the Great Depression or as Japan faced for a decade. I do not believe this is a serious threat. Although the recent dramatic declines in energy prices have led to declines in the monthly headline CPI, it still increased 3.7 percent over the last 12 months while core CPI increased 2.3 percent. So we are not close to a sustained deflation. The recent declines are simply the mirror image of the increases we saw earlier in the year. As long as inflation expectations remain well anchored, these declines in energy prices are unlikely to lead to sustained deflation any more than their previous increases were likely to lead to sustained inflation.

To help anchor expectations, the Fed must credibly commit to preventing sustained deflation from becoming widely anticipated, just as it must prevent sustained inflation from becoming widely anticipated. I have long argued that monetary policy would benefit from establishing a clear and explicit inflation target as a way of signaling a commitment to keep inflation low and stable. Such an inflation target would be just as valuable in preventing expectations of deflation from materializing.

"We don't expect deflation," Richmond Fed chief Jeffrey Lacker told reporters after a speech to the Tech Council of Maryland.

With the federal funds rate at a low level of 1% and the economy weakening, many Fed watchers have begun to discuss other means of boosting the economy, also called "quantitative easing."

Lacker seemed confident that the Fed has sufficient ammunition, saying that the U.S. central bank has "a wide variety of choices" with which to conduct policy even if interest rates were lowered to zero.

"I don't see our inability to reduce the funds rate below zero as hampering our ability to make monetary policy," he commented.

As reported by Market Watch.

The likelihood of deflation, "whatever I thought that risk was four or five months ago, I think it's bigger now, even if it's still small," he said.   But, "A lesson I take from the Japanese experience is not to let that get ahead of us, to be aggressive in moving against that risk if we see it coming," Kohn said, responding to questions following a speech to the Cato Institute's 26th Annual Monetary Policy Conference 

While "some people have argued that we should save our ammunition, that interest rate cuts aren't effective, etcetera, I think that were we to see this possibility that we should be very aggressive with our monetary policy, as aggressive as we can be," Kohn said.   

From the audience Q&A, as reported by Market News