Yesterday, I offered two ungenerous interpretations of the Fed’s unwillingness to take steps to boost the economy. If the Fed believed in textbook macro, then I would think that, if nothing else, they would stop paying interest on reserves.

Today, let me offer a model of the economy that would justify the Fed’s thinking. In this model, it is not possible to set an inflation dial to a precise number. Instead, there are two regimes. In one regime, inflation is low and stable. In the other regime, inflation is high and variable.

The high-inflation regime is quite costly (see the 1970’s), because in it people are spending a lot of real resources trying to conserve on the use of money and trying to extract information from prices that are less reliable signals of relative value. So the Fed is understandably wary of moving to that regime.

I personally find the two-regime thesis quite plausible. It is consistent with my far-from-mainstream view that in most circumstances (the low-inflation regime), open market operations are exchanges of closely substitutable assets, with little or no effect on the economy. The only alternative is for the central bank to go beserk, leading people to believe that prices no longer have any sort of anchor, and causing drastic changes of behavior–not really for the better.

So, the Fed could be thinking that setting an inflation dial to 3 percent is not an option. For small changes in Fed policy, the inflation rate will not be affected. And if the Fed goes beserk, the result will be to move us into the regime of high and variable inflation rates, which will actually be worse.