A senior Wall Street economist predicts US interest rates will be 0% by early next year, raising the spectre of deflation that haunted the Japanese economy for a decade.

Having already cut official interest rates to 1% to stimulate the economy, the Federal Reserve appears to have few weapons left in to fight any deflationary spiral.

JPMorgan Chase economist Michael Feroli says in a note to investors that the Fed will lower borrowing costs by 50 basis points at each of the next two policy meetings on 16 December and
28 January, bringing rates to zero.

Feroli believes that the Federal Open Markets Committee will hold rates at zero for the rest of 2009 in order to prevent prices from spiralling down as companies cut jobs and banks reduce lending, stifling spending and driving down prices.

The Bank of Japan has cut its benchmark rate to 0.3% and the European Central Bank has signalled it's ready to lower rates further after two reductions in the past six weeks.

The Bank of England's nine-member monetary policy committee unanimously backed the decision to slash the central bank's key lending rate to 3% earlier this month, and had even considered deeper cuts according to minutes released yesterday.

A senior US Fed official acknowledged the risk of Japanese-style deflation but downplayed it.
“I think there is a risk of deflation, but it is small,” deputy Fed chairman Donald Kohn said in an address to the Cato Institute.

“I think it more likely that we will get a couple of quarters of negative growth and inflation moderating.”

US consumer prices slumped 1% in October, their biggest fall since 1947, as consumers shun the shops even as retailers slash prices ahead of Christmas.