Another explanation of the Great Inflation focuses on the Fed’s response to output. 2 This view does not regard the Fed’s weak response to inflation as problematic, but the importance it attached to output stabilisation. Indeed, a strongly activist monetary policy, which strives to keep the economy close to potential, suffers from a fundamental conceptual problem.
Although such a policy performs well under ideal conditions, it may well produce markedly sub-optimal outcomes given the inevitable uncertainties associated with estimating the output gap in real time. The latter is what happened during the Great Inflation.