Contemplating the Fed's Encore

However remote the Fed views the threat of deflation, the central bank is highly unlikely to tighten if it sees any possibility of prices spiraling downward, leading to weaker economic activity.

Kasriel wondered how the Fed expects economic growth to resume -- or even exceed -- its trend rate of around 3% if the inflation rate is going to fall further. The current annual rate of inflation is 1.6%, according to the core consumer price index. "If the core falls to 1% in the next six months, that means the 'real' fed funds rate is going up," Kasriel said, referring to the inflation-adjusted fed funds rate. "They're going to be [effectively] tightening policy as this recovery starts to take shape, which could abort the recovery."

Of course, such a scenario assumes inflation doesn't rise in the coming months. Most of those critical about the Fed's decision Wednesday agree deflation is a more imminent risk and, therefore, a 50-basis-point ease would have been more appropriate.

The quarter-point cut "runs counter to the Fed staff's own conclusion from the Japanese experience that monetary policy should act early and aggressively if deflation is a risk," as Goldman Sachs economist Jan Hatzius wrote. (Goldman had forecast a 50-basis-point cut and still expects the fed funds rate to fall to 0.75% by the end of the third quarter.)

At the other end of the spectrum, Richard Bernstein, chief U.S. strategist at Merrill Lynch, suggested that the more the Fed eases, the greater the chance of deflation.

"The Fed's actions continue to lower the cost of capital for the marginal company, which serves to support the economy's overcapacity," Bernstein wrote. "Our concern is that investors will soon be calling Mr. Greenspan 'Greenspan-san' for his Japanese-like strategy of keeping overcapacity alive."