The Fed's Next Move: Hibernation

Yesterday I commented on the role of inflation in the crisis, which was explored at length during a symposium on Dealing with America's Debt Overhang. Any good conversation about inflation has to be followed with a discussion about the Federal Reserve.

Liaquat Ahamed, author of Lords of Finance: the Bankers Who Broke the World, gave a summary of the Fed's exceptional role during the crisis, which can be broken down into three key areas:

1. Acting as a lender of last resort
2. Aggressively cutting interest rates
3. Lending against assets that would normally be considered unacceptable collateral

The Bernanke Fed has been lauded for having prevented another Great Depression, and many, including Barack Obama, consider Bernanke to have been the right man for the right job at the right time.

But times are changing, and now that we are no longer looking into the abyss, what's next for the Fed? What role should it play in the recovery?

One thing the Fed won't be doing over the next years is raising interest rates. The consensus among most economists at the conference was that rates will remain between 0 and 1 percent over the next 5 years. The market seems to agree, as the dollar has replaced the yen as the premiere low-yield, carry trade currency.

Ahamed sees a less activist role for the Fed in the future. It will be primarily concerned with carrying out a passive monetary policy, shrinking its balance sheet, and intervening in credit markets when necessary.

Much like his predecessor, Alan Greenspan, Bernanke didn't think the Fed should actively deflate asset price bubbles. As the Fed assumes a less prominent role, one can only hope that Bernanke is willing to take a preemptive role in targeting potential economic dangers, rather than waiting until a crisis has arrived before rising to the occasion.