In the 1970's soaring prices of oil and other commodities led to stagflation - a combination of high inflation and high unemployment, which left no good policy options. If the Fed cut interest rates to create jobs, it risked causing an inflationary spiral; if it raised interest rates to bring inflation down, it would further increase unemployment. Can it happen again?... …We shouldn't overstate the case: we're not back to the economic misery of the 1970's. But the fact that we're already experiencing mild stagflation means that there will be no good options if something else goes wrong...Thus, in a hard landing, Krugman says “there will be no good options.” But the Fed will need to do something. What should the Fed do in a hard landing? Raise rates? Lower rates? I believe a recession will put the brakes on inflation, and if underlying real factors are the cause of inflation, aggregate demand policy isn't an effective tool for overcoming such shocks. Thus, I would lower rates in response to a slowdown if that were possible. But that is predicated upon the output slowdown counterbalancing inflationary pressure from other sources, and the possibility of lowering interest rates enough to stimulate the economy.
All of these questions would be much easier if both monetary and fiscal policy hadn’t already been used to such an extent. With deficits as high as they are, using fiscal policy to stimulate the economy is politically and economically infeasible. With interest rates this low it’s hard to get much stimulation from driving them even lower. They can't go much lower in any case, though interest rates could be raised if the Fed decides to tighten in response to a stagflationary episode. Thus, because the usual tools for stimulating the economy are largely unavailable, the result of recent monetary and fiscal policy is increased vulnerability to negative output shocks and a stagflationary episode.
[Update: I posted a similar comment at Angry Bear on 4/22 and at macroblog on 4/21 so I thought I'd add it here as well. Holding down interest rates while maintaining the inflationary expectations anchor is a difficult task that must be performed by the Fed in a landing where output falls substantially. Making this task difficult is that the target rate of output changes when there are real shocks to the economy such as an increase in real oil prices. If the Fed mistakenly shoots at too high of a target due to a failure to completely account for the fall in the natural rate of output then it becomes even more likely that they will inadvertently generate inflation and lose the expectations anchor. As David Altig has reminded us, that was a problem for the Fed in the 1970's and hopefully they have learned some important lessons from that episode. My perception is that they have, at least that's my reading from what I've seen from the statements and speeches put out by the various regional bank presidents. But the task is a hard one, on that I think we all agree.]