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Specialist Joseph Mastrolia, left, and trader Glen Kessler work on the floor of the New York Stock Exchange Tuesday, Oct. 14, 2014.Richard Drew/The Associated Press

An influential U.S. Federal Reserve official has suggested the central bank should extend its soon-to-expire asset-purchase stimulus program, in light of rising economic uncertainty and a worrisome plunge in bond yields that suggest disinflation fears are back.

"Inflation expectations are dropping in the U.S., and that is something a central bank can't abide," said James Bullard, who is Federal Reserve Bank of St. Louis president and a member of the Fed's policy-setting Federal Open Market Committee. For that reason, Mr. Bullard said in an interview with Bloomberg News, the Fed should consider maintaining its bond-buying program, a form of monetary stimulus known as quantitative easing (or QE). That program has been gradually tapering down since January and was expected to end this month. The end of QE is widely seen as a precursor to interest-rate increases in the first half of next year.

"I think a reasonable response from the Fed in this situation would be to … go on pause on the taper at this juncture and wait until we see how the data shakes out into December. Continue with QE at a very low level, as we have it right now, and then assess our options going forward," he said.

Mr. Bullard's surprisingly candid comments provided a welcome respite to financial markets that have been in a free-fall for much of the past week. Bond yields stabilized while stock markets and oil prices rebounded.

Even though Mr. Bullard doesn't have a vote in the committee's next policy decision on Oct. 29, the market reaction reflected a growing desire for the Fed to bend in the direction of deteriorating market sentiment.

Tumbling bond yields – which fell as low as 1.86 per cent in the U.S. 10-year bond Wednesday – imply that traders are both lowering inflation expectations and voting against a widely expected Fed policy-rate increase in the next year.

The big threat of deepening disinflation, or even an economy-crushing bout of deflation, lies in continental Europe, which is in danger of taking a third dip into recession and where the euro zone's year-over-year inflation slumped to just 0.3 per cent in September.

But the market turmoil, driven in part by fears of a slumping Europe, has now become a

key fuel for rising doubts surrounding U.S. inflation. Rising aversion to a growing list of global risks has sent investors to the traditional haven of U.S. assets, sparking a U.S.-dollar rally that could effectively reduce the prices for imported goods for U.S. consumers.

This flight to safety has also sent oil prices tumbling, which could also suppress U.S. inflation from reaching the more normal and healthy levels that the Fed is committed to attaining.

But the market's loss of confidence is at odds with the underlying economic conditions in the United States, which continue to point to inflation-fuelling acceleration.

Thursday's economic reports showed that U.S. weekly new unemployment-benefit claims dropped to their lowest level in more than 14 years, while industrial production surged a better-than-expected 1 per cent in September.

"I think the forecasts for the U.S., based on the data I have today, remain intact. But I'm willing to acknowledge that this is a serious development in the global situation, with the situation in Europe," Mr. Bullard said.

"The policy committee should be cautious about the decline in inflation expectations, which is a serious matter."

Some observers suggested the market turmoil has exposed that liquidity in the global financial system remains fragile, six years after the global liquidity crisis of 2008.

"Theoretically, it is an absence of speculators willing to absorb risk," said Sebastien Galy, senior currency strategist at France's Société Générale, in a note to clients.

"The Fed QE fulfilled this function of risk absorption."

One implication is that the markets feel they still need central banks to help keep the taps open, through actions such as QE.

Observers say the European Central Bank, which to date has only made relatively small steps into QE, may need to make a major foray on the scale of the Fed's QE program in order to convince investors it can put a floor under the euro zone's slide.

A slowing of the Fed's march toward rate increases would also help soothe the market's frayed nerves.

"Our old adage is 'markets stop panicking when policy makers start panicking,'" said Merrill Lynch chief investment strategist Michael Hartnett in a research note.

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