WASHINGTON (Reuters) - Plunging commodity prices could drag U.S. inflation below zero next year and the Federal Reserve will have to stay alert to the risk of a damaging deflation that could erode the economy even if it worries that low interest rates could spark inflation over the longer term.

U.S. Federal Reserve Chairman Ben Bernanke waits to speak to the National Association for Business Economics (NABE) about the current state of the economy in Washington, October 7, 2008. REUTERS/Mitch Dumke

The Fed’s emergency action to offset the credit crisis has included slashing interest rates to 1.5 percent and pumping well over $1 trillion into financial markets, which has doubled the size of the Fed’s balance sheet and sent the U.S. money supply soaring.

At some point this could create price pressures, especially if the Fed lowers rates further as many economists expect. Right now, however, it looks like good insurance against an even more damaging dose of deflation.

Deflation is a prolonged and widespread decline in prices that causes consumers and businesses to curbing spending as they wait for prices to fall further. It also increases the burden of any given amount of debt.

Fears of a global recession have triggered a slump in oil prices, which fell to about $70 a barrel last week from a record peak in July of $147.

There has also been a collapse in inflation expectations as measured by the yield spread between 10-year U.S. Treasuries and inflation-index bonds. The spread has shrunk to just 90 basis points from 270 basis points over the last three months.

“Bond markets are more worried about deflation than inflation,” said Michael Darda, chief economist at MKM partners in Greenwich, Connecticut.

Fed Vice Chairman Donald Kohn noted in a speech on Wednesday that lower commodity prices should lead to a sharp reduction in headline inflation.

Dean Maki, chief U.S. economist at Barclays Capital in New York, estimates that the year-on-year change in U.S. consumer inflation will slip to zero or even fall slightly by July.

COMPLICATING POLICY

Policy-makers will not be too concerned that a potentially damaging deflation is taking root, provided the decline does not start showing up in so-called core inflation, which excludes energy and food prices.

But if the economy is still weak and core prices converge downward toward headline inflation near zero, the U.S. central bank could become concerned.

Japan confronted a period of damaging deflation after its property and stock market bubbles burst in the early 1990s, inflicting a “lost decade” of economic stagnation. Some analysts fear the United States faces a similar threat from its housing meltdown.

If deflation risks were to rise, it would make it harder for the Fed to gauge when it should begin withdrawing the enormous monetary stimulus it has unleashed to protect the U.S. economy, and this could lead to policy mistakes.

“I think deflation Japan-style is unlikely here. Higher inflation here seems unlikely for a year or two, but I worry about the longer run outlook,” said William Poole, a senior fellow at the Cato Institute who retired as president of the Federal Reserve Bank of St. Louis in March.

When former Fed Chairman Alan Greenspan declared in 2003 that he wanted a broad firebreak to guard against deflation, the Fed wound up cutting interest rates to 1 percent and keeping them there for a year. Many now claim that this laid the foundation for the current credit crisis by inflating the housing bubble.

During that episode, as now, the Fed looked to Japan’s experience to inform its own behavior. U.S. policy-makers believe that unlike earlier this decade, the risk of a fresh bubble is very small since credit is not available.

This belief has given them the comfort to move aggressively to settle markets and protect the economy.

“If they were doing nothing, you could very well have a deflationary collapse,” Darda said. “Central banks of the world know how to stop deflation. You just print enough money.”