On Friday, Federal Reserve Chairman Ben Bernanke all but promised that another round of monetary expansion is imminent. He emphasized that to take such a drastic measure, both aspects of the Fed's mandate would have to be invoked. Obviously unemployment is too high, and lately inflation has also been lower than U.S. central bankers would prefer. It's easy to understand why high unemployment is awful, but what's so bad about low inflation?
In fact, a 1% inflation rate isn't necessarily worse than a 2% inflation rate -- it's more about expectations. Since the market understands that the Fed targets an inflation rate of around 2%, when it sinks well below that, as it has recently, then the market may begin to change its expectation of the Fed's ability and desire to hit that target. This risk becomes even greater when interest rates are already near zero, as the Fed would have to rely on alternative means to raise prices. So the market's expectation could potentially lead to deflation -- particularly in a time when the economy is very slow and firms might already be cutting prices to conjure up more consumer demand.
So the problem is more one of instability. The fear is that deflation could eventually result if inflation is allowed to decline below its target. Deflation is a particularly dangerous problem, because central banks don't have strong tools to fight a deflationary spiral.