Oct. 14 (Bloomberg) -- The Federal Reserve should avoid provoking inflation by not relying too much on interest rate policy to stem financial market turmoil, said James Bullard, president of the Federal Reserve Bank of St. Louis.

``Overreliance on interest rate policy in this environment does little to solve the problems at hand and, in addition, may cause a new and difficult-to-solve inflation problem in the wake of the current turbulence,'' Bullard said today in a speech in Memphis. More targeted steps can ease the credit crisis, while ``much blunter interest rate policy'' largely ``determines medium-term inflation.''

The Fed, European Central Bank and four other central banks cut interest rates last week in an unprecedented coordinated effort to prevent a freeze in credit markets from causing a global recession. The Fed reduced its benchmark rate to 1.5 percent. Traders anticipate the Federal Open Market Committee will reduce rates again at an Oct. 28-29 meeting.

The odds of a U.S. recession occurring have ``gone up substantially,'' Bullard told reporters after the speech, citing rising unemployment. Labor Department figures showed Oct. 3 that payrolls fell by 159,000 in September, the biggest reduction in five years. The unemployment rate was 6.1 percent, an increase from 5 percent as recently as April.

Treasury Secretary Henry Paulson today urged banks getting $250 billion of taxpayer funds to channel the money to customers to revive credit. The Treasury is making equity investments in banks as part of a $700 billion rescue plan approved by Congress.

`Downside Risk'

``There is substantial downside risk,'' Bullard said to the Economic Club of Memphis. While there is some possibility that the ``real economic performance is muted but not disastrous,'' another possible scenario is similar to Japan's stagnant growth over a decade, with ``a protracted downturn.''

Bullard's view on rates repeats a theme from his Oct. 2 speech, where he said he favored holding off on additional interest rate cuts. ``Lowering the rate right now maybe isn't the right response,'' Bullard said at the time.

The rout sparked by the collapse of the U.S. subprime mortgage market has cost financial institutions worldwide $637 billion in writedowns and losses since the start of 2007. Firms have raised $612 billion of capital in response.

``The bubble component is out of house prices,'' Bullard said in response to an audience question. He said he disagrees with economists who predict house prices will decline much more.

The Fed is facing increasing evidence that the U.S. may already be in a recession.

`Benign Outcome'

``The U.S. economy by the numbers looks like it is slowing,'' Bullard said. ``If financial market turmoil can be contained, possibly through aggressive government policy, then a relatively benign outcome is possible in which U.S. economic performance is sluggish but does not involve a protracted downturn.''

Manufacturing in the U.S. contracted in September at the fastest pace since the last recession. The Institute for Supply Management's factory index dropped to the lowest level since October 2001, the Tempe, Arizona-based group reported Oct. 1.

The consumer price index fell in August for the first time in almost two years as declining fuel costs and a slowing economy cooled inflation. Prices increased 5.4 percent in the 12 months to August, after increasing 5.6 percent for the 12-month period ending in July for the biggest gain since January 1991.

``There are links between the real economy and inflation but I don't think they are as strong as most people think they are,'' Bullard said.

To contact the reporter on this story: Steve Matthews in Atlanta at smatthews@bloomberg.net;

Last Updated: October 14, 2008 22:42 EDT