Fed Takes On Unprecedented Role

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Ben Bernanke i

U.S. Federal Reserve Chairman Ben Bernanke waits for President Obama to speak last week. Frederic Mishkin, a former Federal Reserve Board governor, says that under Bernanke's leadership the Federal Reserve has gone where it has never gone before. Alex Wong/Getty Images hide caption

toggle caption Alex Wong/Getty Images
Ben Bernanke

U.S. Federal Reserve Chairman Ben Bernanke waits for President Obama to speak last week. Frederic Mishkin, a former Federal Reserve Board governor, says that under Bernanke's leadership the Federal Reserve has gone where it has never gone before.

Alex Wong/Getty Images

Federal Reserve Board policymakers met Wednesday, held interest rates steady and released a statement saying "the pace of economic contraction is slowing."

In other words, the recession may not be over, but it is easing. But not so much that the Fed is ready to stop pumping huge amounts of money into the economy in an effort to get it growing again.

It used to be that the Fed would simply push interest rates up or down to stimulate or rein in the economy. But the financial crisis has forced extreme measures that some worry could increase risks to the economy in the future.

The 'Bernanke Fed'

Frederic Mishkin resigned his position as a Federal Reserve Board governor last September, just before things got really interesting. He was around for the Fed's rescue of the investment bank Bear Stearns in March. Then in September, the Fed rescued insurance giant AIG. Both actions were unprecedented.

"There's no question that the Fed has gone where the Federal Reserve has never gone before: the Bernanke Fed," Mishkin says.

The Fed has flooded the economy with money to keep interest rates low. It has also invented a variety of special programs to address the credit crisis, making money available for home loans, car loans, credit cards, student loans and business loans. All together, the Fed has injected over $1 trillion into the economy and could more than double that amount before the recession ends.

Mishkin says there are costs and dangers associated with these policies: "Absolutely, but the alternative is if they were not done, I think, there would have been a very good possibility we would have had a depression. It could have been far, far worse."

Dangers To Avoid

So what are the dangers? Well, the Fed has already acknowledged losses on its loans to rescue Bear Stearns. It could suffer more losses on AIG — some experts think as much as $100 billion. But the big question is whether the Fed can begin to withdraw the mountain of cash poured into the economy to support credit before it sparks a damaging bout of inflation.

Fed Chairman Ben Bernanke says he's confident the Fed is up to the task. Mishkin agrees. He says the big challenge is timing. The Fed doesn't want to step on the brakes too fast and abort the recovery, or stay on the accelerator too long and provide fuel for inflation.

"This is uncharted waters," Mishkin says. "It's going to be more complicated. And that's why no central bank would want to get involved in these kinds of activities unless it was an emergency situation."

Concerns Over Inflation

Professor Allan Meltzer of Carnegie Mellon University is skeptical. He doesn't think the Fed will be able to remove the massive stimulus from the economy before inflation erupts.

"I have no reason to believe that that would happen, because it's only happened once, and that was when Paul Volcker did it," he says.

And Volcker, a former Fed chairman, had politics on his side. Back in the early 1980s, Volcker was able to raise interest rates sharply to curb inflation because the public saw inflation as the major economic problem. That won't be the case this time, says Meltzer, because to win the fight against inflation, the Fed will have to start stepping on the brakes while unemployment is still high.

"Will the administration, the Congress, the business community, the labor unions let them do that while the unemployment is still 7, 8, 9 percent?" Meltzer says.

The answer is no, he says. Even though the Fed is an independent agency, it won't be able to withstand the political pressures.

Additional Responsibilities

Complicating this whole debate is the president's proposal to give the Fed additional responsibilities. The White House wants to make the Fed the so-called systemic regulator, giving it authority to oversee big, interconnected financial firms whose failure could threaten the whole financial system. Mishkin thinks the Fed's experience regulating bank holding companies gives it the expertise, but he says the Fed will need more resources.

Meltzer, who is writing a history of the Fed, thinks the central bank's track record as a regulator shows it often doesn't see trouble coming.

"When the Continental Illinois Bank failed, Paul Volcker was out in a fishing camp. He learned about the crisis when the chairman of the bank came out and told him about it. Who's going to know more about the risks on the balance sheets of the bank, the regulator or the banker? I say the banker," he says.

So Meltzer says the way to make sure a bank doesn't get so big it threatens the whole system is to penalize it by making it put aside more reserves against losses. That would make getting big less profitable. And it's an idea President Obama also has in his plan.



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