updated 12/16/2008 2:53:03 PM ET 2008-12-16T19:53:03

A record plunge in consumer prices in November puts pressure on the Federal Reserve to act decisively to guard against a debilitating bout of deflation.

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The Federal Reserve Tuesday cut its target for a key interest rate to the lowest level on record and pledged to use "all available tools" to combat a severe financial crisis and prolonged recession.

It also said it believes that inflationary pressures have diminished. "In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters," the Fed said in a statement accompanying its decision on interest rates.

Consumer prices, an inflation barometer, last month fell by the largest amount on records going back 61 years as energy costs posted nearly double the decline of the previous month, the Labor Department reported Tuesday.

Prices fell 1.7 percent, surpassing the previous record decline of 1 percent set in October. It was the largest one-month decline dating to February 1947. Core inflation, excluding food and energy, was flat in November after a 0.1 percent drop in October.

The overall slide in prices reflects the big drop in energy costs in recent months. After hitting a record at $147 per barrel in mid-July, crude oil has fallen by $100 per barrel since then, pushing down the price of gasoline from a record $4.11 per gallon in July to $1.34 in the most recent Energy Department survey.

Falling prices for goods and services might sound like a good thing for consumers, but a continued downward spiral can wreak economic havoc. During deflationary periods, companies earning less react by slowing production and cutting jobs, which causes consumers to scale back spending even more. The pattern is hard to stop because it feeds on itself.

In other economic news, the Commerce Department reported that construction of new homes fell in November by 18.9 percent, the biggest drop in a quarter-century. The steep decline pushed construction down to a seasonally adjusted annual rate of 625,000 homes, the slowest pace on records dating to 1959.

The Bush administration sought to highlight the positive impact of rapidly falling inflation.

"Lower inflation data is certainly welcome for the American people," said deputy press secretary Tony Fratto. "The significant drop in energy prices acts like a huge tax cut in our economy."

Private economists predicted further price declines in coming months as the deepening recession cuts further into consumer demand, forcing businesses to reduce prices further as they try to spur sales.

"With fuel prices falling further in December and the deepening U.S. economic recession applying a growing damper on most other prices, inflation is destined to ease further," predicted Michael Gregory of BMO Capital Markets.

Only a few months ago, some anticipated that the Fed would start raising interest rates to battle a prolonged surge in energy costs. But since September, the Fed's focus has switched to trying to prevent the worst financial crisis since the 1930s from pushing the country into a deeper recession.

Energy prices fell by 17 percent in November, nearly double the 8.6 percent decline in October. Both declines represented record drops. Gasoline costs fell by a record 29.5 percent in November, while home heating oil costs were down 14.6 percent and natural gas prices were off 5.2 percent.

Food costs posted a modest 0.2 percent rise in November, the smallest increase in eight months.

The 1.7 percent decline in consumer prices was larger than the 1.2 percent drop that economists had been expecting. It left inflation rising over the past 12 months by 1.1 percent, the smallest 12-month increase since June 2002. Inflation has not risen at a slower pace since a 1 percent rise in the 12 months ending in February 1965.

New car costs fell by 0.6 percent in November, underscoring the troubles facing auto companies as demand plunges in the weak economy. General Motors Corp., Chrysler LLC and Ford Motor Co. are appealing for a government lifeline, and the Bush administration has said it is considering what type of support to provide.

Airline prices fell by 4 percent in November, reflecting the big declines in fuel prices, while clothing costs were up 0.3 percent, a rise that followed a 1 percent drop in October.

The drop in housing starts was the steepest since March 1984. The total is far below the 740,000 pace that Wall Street economists expected.

Applications for building permits, considered a good sign of future activity, fell by 15.6 percent to 616,000, from an upwardly revised figure of 730,000 in October. Economists expected an annual rate of 700,000 permits, according to a survey by Thomson Reuters.

The housing starts and permit figures are at all-time lows, breaking records that were set last month.

Builders continue to be discouraged by the prospects of a housing turnaround amid what's likely to be the worst recession in decades, spurring rising unemployment and foreclosures.

More dour housing news came Monday, as the National Association of Home Builders/Wells Fargo housing market index held at a record-low level of nine in December for the second straight month.

"It is going to be a very cold winter indeed for homebuilders," Joshua Shapiro, chief U.S. economist for forecasting firm MFR Inc., wrote in a note to clients Monday.

More on: Deflation   |  housing market

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