James Bullard, president of the St. Louis Federal Reserve Bank, has spent most of his career figuring out how to fight inflation. So when he stands up and says that what we need is more inflation, people should take notice.

In a speech today in New York, Bullard emphasized the danger that deflation poses for the U.S. economy:

… there is a risk that core prices may continue to stagnate or decline slightly for some time to come. Should lingering financial turmoil continue to weigh on the economy and stretch the recession out still longer, the zero or negative inflation could continue through 2009. Over that time frame, deflationary expectations could become entrenched. For this reason I think we face some risk — at this point only a risk — of sustained deflation. One important near-term goal for monetary policy is to guide the economy away from this outcome.

Having already pushed short-term interest rates to zero, the Fed has lost its traditional tool for managing the economy. But, echoing the theme of a recent speech in St. Louis, Bullard said the Fed still has a powerful way to fight deflation. By inflating its balance sheet, the Fed can expand the monetary base, creating reserves that banks will use to make loans.

The monetary base has more than doubled since September, Bullard said, but some of the expansion can be viewed as temporary. As the Fed carries out its announced program to buy mortgage-backed securities and other assets, the balance-sheet expansion should be viewed as permanent, he said, and

it is these purchases that may provide enough expansion in the monetary base to offset the risk of further disinflation and possible deflation. The quantitative effects of policy actions in this new environment are more uncertain than normal, but nevertheless these less-conventional policies can have every bit as powerful an impact on the economy as changes in the intended federal funds rate.