IMPEACH BUSH

NEW YORK (Reuters) - If economics had a Grim Reaper, it would be deflation.

A downward spiral of prices, earnings and economic activity, it may be the most difficult problem for officials to fix. Deflation is best remembered for the severe economic hardship it caused in the United States during the Great Depression.

Financial markets will confront this specter on Tuesday, when U.S. data is expected to show another monthly drop in prices as the year-old recession cuts into consumer demand for everything from cars to casual wear and gasoline to groceries.

Economists debate whether the price drops seen so far constitute deflation, and some say more evidence is needed. But they also say the danger signs are unmistakable.

"Markets already are very worried about deflation," said Carl Lantz, U.S. interest rate strategist at Credit Suisse in New York.

"We are kind of already there. The question is whether the deflation is very persistent. Our best guess is it's not."

Lantz said deflation may hobble the economy "for a few quarters" but if President-elect Barack Obama launches the huge economic stimulus package that many expect next year, then deflation should dissipate.

For the present, however, price declines are the story.

Economists expect consumer prices to post a record monthly drop of 1.2 percent for November after a 1.0 percent fall during the previous month, which was the biggest on record.

According to the median of forecasts in a Reuters poll, they expect annual consumer price inflation to come in at 1.5 percent for November, down sharply from 3.7 percent in October.

The data comes on the same day the Federal Reserve ends its two-day policy meeting, with markets widely expecting it to cut rates by least half a percentage point.

This would leave the target federal rate at just 0.5 percent, close enough to zero to heighten worries that the Fed has lost control of the shrinking economy despite considerable efforts.

TRAPPED

Besides cutting rates by a whopping 4.25 percentage points over the last year, the Fed has undertaken extraordinary measures to make the banking sector more liquid and ease monetary conditions throughout the economy.

These appear to have had little success in slowing the rapid descent of the economy, which is on track for its longest downturn since the Great Depression.

"You can create the liquidity, but if the banks don't lend it, you're in a trap," said Brian Fabbri, managing director of economic research at BNP Paribas in New York.

"By printing money, enough of it, sooner or later it will begin circulating. Right now, it hasn't truly circulated. Banks are not lending money to anyone," Fabbri said.

Textbooks define deflation as a persistent and general fall in prices, often associated with the reduction of money supply or credit.

They caution against confusing this with disinflation, which is a slowing of the rate of increase in prices.

With the annual inflation rate still positive, but declining, the condition of the United States may seem more like disinflation. Some economists say they will wait for year-over-year prices to drop to declare outright deflation.

"I think when year-on-year is negative, I think it's fair to say now we're in deflation," Fabbri said, though he cautioned that precise definitions are hard to come by.

"We're not ready to talk about deflation until about May of next year," Fabbri added.

Others say deflation is already in the early stages, especially considering that the monthly drop in price levels is occurring amid a severe credit crisis.

Nowhere is the peril of a deflationary spiral more evident than in the auto sector. New car prices have fallen for three months running, credit for potential buyers is the tightest in years and auto production is plummeting, leaving U.S. carmakers begging for a federal bailout.

In the short term, though, falling prices are good for consumers, who struggled with a high inflation rate throughout the year and are now under pressure from rising unemployment.

It will also aid the Fed's attempt to stimulate the moribund economy through low interest rates. However, the symptoms of deflation are increasingly what the Fed is fighting, rather than a more traditional economic slowdown.

"In the short term, I think we are in deflation," said Howard Simons, strategist at Bianco Research in Chicago.

"Let's look for more weak numbers in short-term inflation. Going forward we're not going to have anything that is going to be an upward inflationary pressure until things get better."

(Reporting by Burton Frierson; Editing by Jonathan Oatis)