I'd like to start off by saying that I thoroughly disagree with Steven Landsburg's post on deflation, found here: http://www.thebigquestions.com/2010/08/03/deflation-followup/.
The post completely ignores the savings/investment mechanism. In my mental model (perhaps someone with a better model can verify or correct this), in deflation, those things can decouple, because deflation means that spending money now is less appealing - everyone would rather wait a period and borrow less to finance their investment. Underinvestment in the US seems to be a chronic problem that deflation would only worsen.
The Fed's reluctance to hit its own inflation target makes no sense to me - it's throwing away free nominal economic growth at a time when nominal economic growth would reduce unemployment. This has been pointed out by Sumner, Krugman and Cowen, among others. I think the Fed should be printing money at full speed, and buying back either government or corporate bonds. It should be reducing the interest rates on reserves (I've heard that reducing it all the way to zero would cause some other mechanisms to break down, but it's currently at 25bps, and should be somewhat reducible with only small changes in policy).
The question, of course, is why aren't they doing this? I'm sure they're worried about something - perhaps they think they can't hit the inflation target with any precision and they'd rather stay where we are than risk overshooting. Perhaps I overestimate the Fed but it seems like there's no way they'll overshoot beyond a few percentage points, and 4.5% inflation will not cause an inflationary spiral. So unless they think they're much less powerful than I do, the current course makes no sense.
Maybe I'm underestimating the magnitude or consequences of a potential overshoot, but I suspect there may be a secondary problem as well.
I've noted a number of times that I'm worried about inflation - as a result of China, chronicled a number of times on this site (see the "links" section on the side of this page, or go read Michael Pettis' blog), as well as a result of fiscal deficits. Fiscal deficits can create problems for inflation on a number of levels - there's the more classic "governments print money to pay off their debt" issue, but in the intermediate term, before there's an issue, I have a theory for another problem - the "rigid financing models" problem.
The "rigid financing models" story goes something like this: Fiscal deficits mean interest rates should increase as a risk premium is eventually applied. This risk premium should be separate from the effect of government rates on consumer rates, as long as nobody's really concerned about the government printing money - the spread should be equal to the relative risks. However, you also have an issue of financiers' existing models. Most of finance treats American bonds as risk-free, and if that's the case, consumer interest rates climb too high as they maintain a risk and liquidity spread over supposedly risk-free (and actually liquid) US government bonds.
That initial interest rate spike can slow the economy, so in order to stimulate the economy, the Fed needs to cut the actual, pre-risk premium rate too low to get consumer rates in line, which causes inflation. That may actually delay the fiscal problem as the economy overheats, tax revenues shoot up, and inflation minimizes the problems presented by our existing debt base. Eventually that pops and shit hits the fan.
However, both of these fiscal stories are very separate from the inflation that most Fed hawks seem to worry about. The fiscal story is structural; there's not much the Fed can do. The Fed seems to be worried about the monetary side - if velocity starts to recover, then inflation happens because of the massively increased monetary base.
However, if that were to happen, it'd seem that the Fed could just turn around and raise interest rates slowly, reversing the most recent policies (perhaps reinstituting interest on reserves, or selling off some of the bonds it bought).
Concerns about fiscally-derived inflation are very real and legitimate, but monetary-derived inflation seems much more controllable, and conflating the issues in public dialogue may have put too many hawks on the Fed. I don't like inflation at all, it scares me a lot, but inflation that is a little (or even moderately) too high is still way, way less scary than deflation. On an upside-downside basis, I'm not quite sure why the Fed isn't doing more, especially given (to reintroduce this point) they're MISSING THEIR OWN INFLATION TARGET.