What's the Fed thinking?

At the August 10 meeting the Fed was confronted with 9.5% unemployment, inflation below the 2% target, and a visibly slowing economy. The proposal on the table was to begin reinvesting proceeds from the Fed's portfolio of bonds. To recap, the Fed had purchased about $2 trillion of government bonds and mortgages in 2009-10 (creating that amount in bank reserves) in order to stimulate the economy. In March the Fed stopped new purchases, which meant that as bonds matured the Fed was turning money back to the Treasury, shrinking its holdings of bonds and reducing bank reserves. Reinvesting the proceeds instead would maintain the size of the Fed's balance sheet and therefore maintain the amount of monetary stimulus being provided.

This seems to me to be an easy call. Any tightening of monetary policy is inappropriate given the weakness in the economy, even if that tightening occurs in a passive way. But as this article by Jon Hilsenrath shows, at least seven of seventeen FOMC members were opposed to the proposal or expressed reservations. Kevin Warsh thought reinvesting the bond proceeds would send a signal to investors that the Fed was paving the way for more aggressive actions in the future, which he would not support. "Some officials" thought they needed more information about the economy before they could support such a move. Richard Fisher thought more bond purchases wouldn't do any good since banks were already flush with reserves. Charles Plosser argued that action wasn't necessary because growth projections for 2011 had not changed. And Narayana Kocherlakota argued that the economy was suffering from a problem of mismatch between available jobs and skills, which monetary policy could not resolve.

Paul Krugman rightly takes Kocherlakota to task for adhering to a primitive form of the "hangover theory" that says that recessions are needed to facilitate the movement of workers from one sector of the economy to the other. This is indeed a nonsensical argument - there's no reason workers can't be pulled into new sectors through higher wages and a booming economy instead of pushed by unemployment, and at any rate all sectors of the economy have seen declines in employment during this recession. But it seems to me that the most important cause of the Fed's reluctance to act is timidity, an excess of caution. For some reason 9.5% unemployment, declining inflation, and a falling GDP growth rate are not sufficient to imbue a significant faction within the Fed with any sort of urgency. That is very odd. The Fed should be doing everything in its power to stimulate the economy and should not stop stimulating until it sees strong growth and a declining unemployment rate.