The New York Times asked me and two others this question for its "Room for Debate" blog. My answer follows. Not news for readers of this blog, but maybe a fun concise summary
Should the Fed risk inflation to spur growth? The Fed is already trying as hard as it can to spur growth, and to create some inflation. The Fed has created about two trillion dollars of money, set interest rates to zero, and promised to keep them there for years. It has bought hundreds of billions of long-term government bonds and mortgages in order to drive those rates down to levels not seen in a half a century.
The fact is, the Fed is basically powerless to create more inflation right now -- or to do anything about growth. Interest rates can't go below zero, and buying one kind of bond while selling another has minuscule effects. Which is just as well. While preventing deflation in the recession was vital -- and the Fed did it -- the idea that a deliberate inflation is the key out of our policy-induced doldrums makes no sense.
Tight monetary policy is not the source of our problems. Monetary policy is loose by any measure. Anti-growth policies are our problem. Our economy is being stifled by over-regulation, chaotic taxes and policy uncertainty. You make money now by lobbying regulators for special treatment, not by starting companies. We fix that with growth-oriented policies that remove the source of the problem.
Inflation remains a danger, but not so much because of what the Fed is doing. U.S. debt is skyrocketing, with no visible plan to pay it back. For the moment, foreigners are still buying prodigious amounts of that debt. But they are mostly buying out of fear that their governments are worse. They are short-term investors, waiting out the storm, not long-term investors confident that the US will pay back its debts. If their fear passes, or they decide some other haven is safer, watch out. The inflation some are hoping for will then come with a vengeance. It's not happening yet: Interest rates are low now. But so were mortgage-backed security rates and Greek government debt rates just a few years ago. And inflation need not happen, if we put our fiscal house in order first. But if it happens, it will happen with little warning, the Fed will be powerless to stop it, and it will bring stagnation rather than prosperity.
Followup thought (more on the last paragraph):
Yes, interest rates are low, and there is little sign of inflation. I hate to use the word "bubble," but US government debt strikes me as a "bubble," meaning "whatever it is you thought was going on with houses, mortgage backed securities and Greek government debt in 2006, or internet stocks in 1998, and used the word "bubble" to describe, is going on with US government debt now."
More precisely, an asset can have a high value (government bond prices are high, interest rates are low) because people think its "fundamental" cashflows are high, or because people are willing to hold the asset for a year or two, and they think they can get out and sell it before its value falls.
It's hard to make a story that US long term debt has a high price (low interest rate) because investors are really impressed with the huge budget surpluses in a credible long-term US fiscal commitment. (!) If you don't buy that story, then the admittedly huge demand for US debt is must be a short-term demand, a low required return, a "flight to quality" that can easily evaporate. It can also easily increase for a few years before it evaporates. Europe does seem to be going down the tubes.
It has to be one or the other though. People (you know who) who say "interest rates are low, inflation is low, the government can borrow huge amounts and blow it on preparations for an alien invasion, don't worry, it's not a bubble, it can't burst" have to assume that markets really trust the government to pay back those debts.