Auditing the Federal Reserve may or may not be a good idea, but one thing seems pretty sure: just discussing it seriously will tend to drive the price of gold higher.

The U.S. House of Representatives Financial Services Committee last week voted to approve an amendment that would bring about an audit of the Fed, its monetary policy and lending programs, since when gold has gone its merry way higher, hitting an all-time high of $1,174 per ounce on Monday.

The amendment, a provision to a broader financial services reform bill that is still under consideration, was co-sponsored by Republican Representative Ron Paul, author of the book “End the Fed,” and the man least likely to be found chairing a panel at Jackson Hole or Davos.

The Fed, understandably, hates the idea, saying it will compromise its hard-won independence, the administration loathes it, and really it will almost certainly never become effective in a recognizable form.

Even so, and even interpreting the vote as a populist cry of the heart against Washington and Wall Street, the fact that it has gotten this far will cause some serious people without an ideological dog in the Federal Reserve fight to buy a bit of gold, which is really a sort of anti-currency, as a hedge against increased political influence in the process of making monetary policy.

Undoubtedly many people who think keeping the Fed on a short leash attached to an elected body is a good thing also think the Federal Reserve should have been much less aggressive in creating money and risking inflation. History shows that the risks are actually skewed the other way: tighter political control of central banks more often means more inflation and a higher risk of a debased currency.

In other words, the people who support this because they think the Fed shouldn’t debase the currency are probably raising the risk that the currency is debased. This just adds to the bid for gold, which is already being supported by concerns that current monetary policy and deficits put inflation and the dollar at risk. These risks are not high, they are tiny, but they are disturbingly more worth discussing now than two years ago.

Thus we are in the bizarre situation of watching the price of gold being driven higher both by people who don’t trust the Federal Reserve and people who don’t trust the people who don’t trust the Federal Reserve.

HOW HIGH IS HIGH?

It has to be said; the very idea of buying gold, which adds nothing to the creation of wealth or innovation and is only conceivably a hedge against bad actions of other people, is dispiriting. If you buy gold you cannot tell yourself that you are doing well by doing good, as perhaps you can with a biotech or fertilizer company. You are simply limiting the damage that can be done to you, and then only in very particular circumstances. What’s more many of the people who advocate it as an asset show a disconcerting monomania; the type who if they sit next to you on a commuter train makes you consider pretending the next stop is yours.

Gold’s real virtue is negative. It is not used for much industrially but there is limited supply and real physical constraint on producing more. Unlike, say dollars, you can’t simply flip a switch and make more.

Dylan Grice, strategist at Societe Generale in London (who, by the way, I’d happily sit next to on a train) points out that the value of the gold held by the Fed only equals 15 percent of the U.S. monetary base and that the price would have to rise to $6,300 per ounce to make the currency fully backed by gold reserves.

Of course, gold is not just going up against the dollar, it is going up against an array of major and minor currencies, indicating that the worries are not simply about the Federal Reserve or U.S. policy but about the interplay between fiat currencies and policy around the world. A tremendous amount of debt has been created and socialized and a lot of money has been created.

Which brings us back to the Federal Reserve and the politics of monetary policy, or as perhaps we will begin to see it the politics of politics. The betting has to be that the Federal Reserve emerges with its independence intact, if not its power as a regulator. From a markets point of view the Senate confirmation hearings for Ben Bernanke’s second four-year term as chairman kick off next week and offer the next opportunity for populist fireworks.

I am looking forward to having fewer conversations about gold, but I am not expecting it.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

New studies from the Federal Reserve and European Central Bank show that, whatever else, a recovery in the economy is not being supported by a resumption in bank lending, raising concerns about how exactly growth will become self-sustaining when official stimulus ebbs.

The ECB last week released its loan survey showing banks tightened credit yet again for businesses and consumers, though at a less severe rate than in the previous quarter. Much was made of the fact that banks said they expected to ease terms to businesses, but not individuals, slightly in the last three months of the year.

Days later the Fed was out with its own survey, and again the news is getting worse more slowly, which must mean it is time to pop open the tap water. Banks are tightening terms and conditions to large firms, though fewer are doing so than before. Of course we should be thankful for small mercies, but the fact remains that this is a relative rather than an absolute survey, which means that even if fewer are being tougher the vast majority are being just as tight with money as they were three months ago when things were very tight indeed.

But wait, I can almost hear you ask, banks are making money again. If not making loans, what are they doing with it? Funny you should ask, they are lending it to the government. According to Fed data October marked the first time in years that banks held the same amount in Treasuries and Fannie Mae and Freddie Mac bonds as they did in commercial and industrial loans. Business loans have plunged 18 percent in a year, while Treasury and agency bonds are up 8 percent.

Banks are choosing to lend to the government and to government-backstopped mortgage firms because they see it as the best way to survive: hunker down, take fewer risks and content yourself with the thin gruel and thin margins of taking deposits and lending to the entity insuring those deposits. It’s a good way to get solvent but it will take a terribly long time.

Falling demand for credit is a factor too. Firms are concentrating on expanding margins by cutting back on costs, rather than positioning themselves for an upswing in demand. That means they want fewer loans to support capital expenditure. It also sadly means that they are not yet hiring.

OF JOB GROWTH AND SMALL FIRMS

The question becomes will the loans be there when companies do decide that it is time to tool up and hire again. There can be no certainty. Banks are still in pretty poor shape, more will fail and few look likely to expand.

If you believed in markets you would believe that this is simply setting the stage for new entrants to come in and make loans that the banks won’t. I’d like to believe this, but here we run into one of the terrible side effects of too-big and too-connected to fail. Who on earth wants to set themselves up in competition with government-backed firms? Some will do extremely well in making loans opportunistically to commercial real estate and industry over the next two years, but fewer than would be the case if there was a truly level playing field.

Two groups are doing reasonably well, but only because they don’t have to rely on bank credit: large credit-worthy borrowers and house buyers. Fannie and Freddie are still cranking out mortgages, and loans backed by the Federal Housing Authority have boomed. Rates are low, and though fees are high and terms tighter it has to be said that the decision to officially support the housing market by tax breaks and subsidized lending is making a difference. It may not be good policy, but it is effective poor policy.

Small firms seem to be getting particularly tough treatment; the Fed survey shows that terms, conditions, pricing and availability were all deteriorating more rapidly for the small than the large and medium-sized companies. Annaly Capital points out that while middle market firms paid only a slight premium in the loans market in 2007 and 2008, the difference between benchmark loans and middle market is now almost 6 full percentage points, meaning they pay nearly double.

A prepackaged bankruptcy for CIT Group and a chastened GE Capital will not improve things.

Two possibilities suggest themselves for how things play out. Banks may get their balance sheets in order and begin to lend again in force next year, meeting a need for investment as economic growth takes root, if indeed it does.

If demand rises and banks can’t meet it, look for more official arm-twisting, more ritual abasement by bankers called before Congress and, ultimately, more official interference in the process, probably in the form of insurance or even mandates.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

Don’t expect the year-long rally in risky assets to be undermined any time soon by the Federal Reserve becoming concerned about inflation.

The old metaphor — that the Fed’s job is to take away the punchbowl just when the party starts getting good — just doesn’t apply in the current circumstances. That’s not to say inflation isn’t a threat in the medium term — it is virtually a promise.

But punchbowl thinking dates from a time when firstly the Fed was presumed to have a degree of control over events we now know is not true and secondly to an era when asset prices were the caboose rather than the engine of the economic train.

Even with an economy that is now growing, the risk of a self-reinforcing de-leveraging spiral is enough to ensure that the Fed will not pull the trigger on tightening any time soon.

“Asset prices are embedded not only in our psyche, but the actual growth rate of our economy. If they don’t go up, economies don’t do well, and when they go down, the economy can be horrid,” Pimco bond chief Bill Gross writes in his most recent letter to investors.

Gross argues that leverage inflated the price of assets even as investment in the U.S. real economy flagged. As this happened the U.S. economy became ever more dependent on asset prices and on the sectors, such as finance, which intermediated the borrowing. When the debt and asset bubble is pinched, the whole edifice is threatened, leading to a response like the one we’ve seen: massive and overwhelming aid trained on markets irrespective of the costs.

Pimco data shows that the prices of assets in the United States over the past 50 years have gone up 1.3 percent a year more than would have been expected given nominal growth in the economy, leading to a putative 100 percent overvaluation if you reason that the assets which depend on the economy for income shouldn’t outgrow it.

Unsurprisingly, the real outperformance of asset prices against economic growth has come in the past 30 years, since when debt growth has accelerated.

There are other explanations for why asset prices have outpaced economic growth. For one thing, off-shoring and outsourcing have both suppressed wages in the United States, leading to higher returns on capital, and increased the income that U.S. assets receive from overseas.

It’s obvious that the past 25 years have not been kind to labor, and as its share of GDP has declined the share going to asset owners has increased. In that sense increasing asset prices make economic sense, though there seems to be every chance that workers start to recapture some of what they have lost.

GROWTH, DEFAULT OR INFLATION?

Taxes on capital and profits have also fallen in the United States, and, like wages, this is a trend that could easily be reversed in coming years, especially given the huge amount of public debt that will have to be paid back.

This brings us to the other very strong reason the Fed may have for not pulling away the punchbowl — or water bowl as perhaps we had better see it — even when the party turns inflationary: public debt.

Since the United States have taken a decision to not allow too much of the private debt to default, it has taken on a corresponding increase in public debt which will have to be repaid ultimately. U.S. debt as a percentage of GDP will exceed 60 percent, a level not seen since World War II.

But unlike the post-war period, Europe doesn’t need  rebuilding and though Asia will grow hugely those profits won’t flow to U.S. coffers.

So, if growth doesn’t allow the United States to repay debts, there are two options, neither pretty; default or inflation.

“No policymaker in the developed world — and, by now, few in the developing world — would want to countenance default as an option,” writes economist Spyros Andreopoulos of Morgan Stanley in London in a note to clients.

“This leaves inflation.”

To be sure, the Federal Reserve takes its mandate to control inflation and its independence seriously, but it is going to find itself in a very difficult squeeze, partly of its own making. The debt is high, growth will be poor and the time for private defaults is past. Threats to its independence will only grow.

Given that, and the dependence of the economy on asset prices, it’s not hard to bet that the evil we will be left with is inflation. Whether it is engineered or just kind of happens is less interesting than the reasonably high likelihood that it will happen at all.

For a time at least, that would argue that risky assets, particularly real assets and emerging markets, do well.

Longer term, things get stickier and stickier.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

- James Saft is a Reuters columnist. The views expressed are his own –

Even putting aside the spectacular but hard-to-measure risks of a financing crisis or the loss of its special status, the dollar faces really serious headwinds from boring old fundamentals.

The dollar has been weak for months and markets have been fretting over a host of big picture worries.

Perhaps the world’s oil exporters will stop using the dollar as the medium for petroleum trade. Or maybe the so-far patient and docile buyers of Treasuries will finally turn jittery. Either could be a disaster for the dollar, but you don’t need conspiracies or crises to be bearish on a currency from a country which on some measures has run the largest-ever deficit between what it imports and what it sells abroad.

One of the most interesting side effects of the first part of the financial crisis was that the dollar actually rose despite being the locus of the credit bubble and despite the U.S. consistently importing far more than it exports. That strength, which has now been reversed in part, was largely because the freezing up of markets set off a scramble for dollars.

The acute phase of the crisis is over and a return to something approaching normalcy is not treating the dollar kindly; from its peak this year the dollar has fallen more than 13 percent against a trade-weighted basket of currencies. The current account deficit — the balance of exports to imports — has also been reduced greatly, from a peak north of 6 percent of GDP to below 3 percent at the end of June, with further narrowing in the months since. That is because a weaker dollar makes U.S. products more competitive, but also because the price of oil, of which the U.S. is a net importer, has dropped, and consumption at home is flagging.

It is far too early, however, to say that the dollar adjustment has done its work and the deficit will now close.

“The U.S. current account shortfall was primarily driven by a consumption surge rather than an acceleration of investment on the back of productivity growth and high profitability,” Citigroup currency strategist Michael Hart wrote in a note to clients.
THINGS THAT CAN’T GO ON FOREVER DON’T

That is bad news for the dollar and bad news for the outlook for U.S. growth. A 2005 paper by Caroline Freund of the World Bank and Frank Warnock at the University of Virginia <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=875699> found worse outcomes for the countries that ran current account deficits to finance consumption as opposed to those which ran deficits in aid of investment.

Industrialized countries which, like the U.S., run current account deficits for consumption, find that the currency depreciation that follows tends to be deeper. What’s more, the adjustment in the deficit lasts longer and is often twinned with lower growth. It is not, I suppose, a big surprise that importing more than you export and then consuming it leads to depressed growth. The real wonder is the way in which the U.S.’s special status and the generous financing terms offered by its trade partners made this possible without more immediate damage to the dollar.

There is also the possibility that globalization has permanently raised the “natural” level of the U.S. current account deficit. Huge swaths of the U.S. manufacturing base and a growing wedge of the country’s service sector have been offshored or simply moved out of the U.S. Many of these goods and services are still consumed by the U.S., but now much of the money generated by those sales will be the result of dollars being sold to buy pesos, ringgits or yuan.

This may place more structural pressure on the dollar to fall over time.

Australia’s decision to raise interest rates last week hurt the dollar and for good reason. It demonstrated that as a recovery happens the action will not be in the U.S., but in resource-based economies and in places, mostly in Asia, where the best prospects for productive investment lie. The U.S., where the Federal Reserve will likely need to keep rates low for a very long time, will have a hard time capturing the imagination of investors.

For policymakers, and not just U.S. ones, the puzzle is how to allow the dollar to fall gently without precipitating trade friction or a disastrous loss of confidence. Because it’s more or less in everyone’s interest, it will probably more or less be avoided. A weaker dollar, though, is simply consistent with the outlook for the U.S.

A long shamble downwards rather than a fall off a cliff looks to be in the dollar’s future.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

Now, faced with years of economic stagnation, most economists conclude interest rates will stay low indefinitely. The Fed is doing little to disabuse them, though an opinion article from Fed Governor Kevin Warsh in today's Wall Street Journal tries to warn us not to get complacent.

Warsh says, a bit technically: "'Whatever it takes'... cannot be an asymmetric mantra, trotted out only during times of deep economic and financial distress, and discarded when the cycle turns." In other words, if the Fed only intervenes during downturns, it risks its credibility as protector of the dollar.

But talk is cheap. Not since Paul Volcker raised rates significantly in the early 1980s has the Fed done anything substantial to fight the forces of irrational exuberance. The Fed won't reestablish its bona fides until it puts the economy through pain.

With a "recovery" under way, the printing press running on high to support the housing market and $850 billion of excess reserves just waiting to spark inflation, the Fed's credibility is, well, strained to say the least.

So Warsh goes a bit further: "Policy likely will need to begin normalization before it is obvious that is necessary, possibly with greater force than is customary ..."

Dollar bears like me like the sound of "greater force than is customary," but we don't believe the Fed would actually use it.

Why should we? Earlier this week, the central bank put out another wishy-washy policy statement that says it will hold interest rates low "for an extended period," while gradually weaning the economy from the support of the printing press.

That will only encourage investors to take on risks that will tie the Fed's hands later on.

To avoid a return to that status quo, we need more than tough talk. We need a fire drill -- a quick, small rate increase that no one is expecting.

Always telegraphing your moves months in advance is what breeds complacency. Investors make stupid mistakes and the Fed is left to pick up the pieces, putting the dollar at risk.

So, Kevin, if you're worried about investor complacency, give us a rate increase when we least expect it. Perhaps next week?

There is a long list of outfits which have done well out of the banking bailout, but the U.S. Treasury and Federal Reserve are not among them.

According to calculations made for the New York Times, the Treasury’s Troubled Asset Relief Program (TARP) has reaped profits of about $4 billion, or 15 percent annualized, as eight of the largest banks to participate have fully repaid what they owe.

Meanwhile unnamed Federal Reserve officials told the Financial Times that the central bank’s liquidity facilities have generated a “gain” of $14 billion since August of 2007.

The notion of TARP profits is only true if looked at in the narrowest sense, and even then may prove to be a return as real as those of the Florida condo flippers in the summer of 2007.

The Fed, on the other hand, incontrovertibly has earned more by buying and lending against poorer quality paper, but they did it by taking on more risk - a leaf out of the book of the industry they were helping to rescue.

Wait until the Fed starts making payday loans or gets into the reconditioned small appliance finance business, then you will see what kind of “gains” a bank with a printing press and the power to create money can really generate.

I suppose the idea is to make taxpayers and voters grateful that they had the opportunity to participate in such profitable ventures - doing well by doing good, or some similar fluff.

A number of leading banks have repaid their loans made under TARP, and the government has profited by warrants it held under the deals, but this is really only a bit of runoff from the great jet of liquidity that the government has concentrated on the industry as a whole.

“What this is more appropriately described as is a return of capital; to call this a profit is to ignore trillions of dollars in taxpayer monies that have been spent, lent, guaranteed, drawn against and otherwise consumed in what will likely be the greatest transfer of wealth in the planet’s history,” Barry Ritholz, of research firm Fusion IQ, wrote on his blog.

It is one thing to justify an enormous outlay and subsidy - and make no mistake this is what the bailouts were - on the basis that it was a needed evil, but it borders on the offensive to sell it as a successful investment.

DOING WELL FROM DOING LESS

The first to repay within any loan portfolio are by definition the strongest; it is only later that the laggards show the losses. We do not know how the TARP and other programs of support will look in three or four years time, but it is likely to be worse than they look today.

Moreover, the whole idea of rigging the game and then declaring a profit is wrong. Governments can ever and always create the conditions under which their financial sectors can turn nominal profits.

They do this in a number of ways; through lax regulation, by engineering low interest rates with a sharply sloping yield curve, by limiting competition, or by providing term financing when the markets won’t do so.

These profits though are effectively a tax on the rest of the economy, and I am betting that the taxpayer and government are not getting their fair share, which is virtually all of it.

Billions and billions of dollars are flowing elsewhere - to investors, to borrowers and to employees.

There is also the bald fact that, given that there were no effective funding markets at the time that many of the loans and investments were made, the government could have extracted far higher compensation for its support.

And what about opportunity cost? How would the government and taxpayer have fared if instead of rescuing the banks, and thereby privatizing much of the profit, it seized them and sold them off in the normal fashion? Or what about if the trillions of dollars in support were used in different ways, for different purposes, or even, heaven forfend, not spent at all?

As for the Fed and its gains, the key point is that this money, which represents the extra earned above what three-month Treasury bills would have generated, is not risk adjusted.

The Fed isn’t, and shouldn’t be, a hedge fund — leveraging up and going out the risk curve to generate profits.

It too, conceivably, can allocate credit to a particular part of the economy, say housing, and thereby make the loans it makes to that sector perform and generate “profits.” But this begs two questions; is it right for them to allocate credit in this way and are the profits real or symptoms of a bubble?

This will work for a while, but as we have seen, not forever.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

Since getting the job, Benmosche has spent more time at his lavish Croatian villa on the Adriatic coast than at the troubled insurer's corporate offices in New York.

And in the short term, Benmosche's vacation strategy appears to be paying dividends.

This week, AIG's shares surged 44 percent, to nearly $50, after Benmosche said that he intended to move slower than his predecessor in selling off AIG's still viable divisions.

Maybe Benmosche should consider relocating AIG's headquarters to Dubrovnik.

But the big run-up in AIG shares is merely a sideshow for momentum players, speculators and Hank Greenberg, the former AIG chieftain who controls about 11 percent of the company's outstanding shares.

The reality is that AIG exists today only because of the $180 billion lifeline the insurer has received from the federal government. Even Benmosche acknowledges that, telling The Wall Street Journal: "If the U.S. government doesn't continue to support AIG, we will fail."

The trouble is that the government continues to act as if its support of AIG is unconditional, which is why Benmosche can feel free to set his own leisurely timetable for selling AIG's assets. The former MetLife chief executive knows no one from the government is about to tell him what to do, even though American taxpayers effectively own 80 percent of the company.

But Treasury and the Federal Reserve need to be taking their cue from the Federal Deposit Insurance Corp in how to handle AIG.

Behind the scenes, Sheila Bair, the FDIC chairman, has been exerting a lot of pressure on her agency's biggest ward--Citigroup--to make changes to its management and business strategies. Treasury and the Fed should do much the same with AIG.

There's no reason for the federal government to be acting as a mere bystander in all this. After all, the government bailed out AIG chiefly to prevent a run on U.S. and European banks that had purchased hundreds of billions of dollars in guarantees on risky securities. In those scary days immediately following Lehman Brothers' collapse, AIG was too big to fail.

But nearly a year later, that is no longer the case. If AIG were to fail now it would be painful but more manageable because of the steps the Fed has taken either to guarantee or remove the most troubling assets from its balance sheet.

Yet the government's kowtowing to AIG leaves some scratching their heads.

"The controlling party here should be the government," says Brad Golding, a hedge fund manager with Christofferson, Robb & Co, who frequently shorts financial stocks, including shares of AIG in the past. "When he was made CEO, (government officials) should have called him and said: 'You are occupying this role at our whim.'"

There's talk about the Obama administration using the one-year anniversary of the demise of Lehman Brothers to give new life to its flagging financial regulatory reform package.

That's a fine idea and one that's no doubt necessary in light of the way many on Wall Street are returning to business as usual.

But here's something else Team Obama should do: Use the anniversary of the AIG bailout to set a hard-and-fast deadline for dismantling the insurer and getting the taxpayers' money back.

In recent months, however, this economic supervillain seems to have lost its power to intimidate.

With growth reviving, many economists now believe that deflation is highly unlikely to materialize.

Another group suggests that deflation is not nearly as nefarious as often portrayed. Since falling prices are not generally associated with depression, we were wrong to be frightened in the first place.

Sadly, both of these reassuring premises are wrong. We should still be afraid of deflation.

First, the notion that deflation is a misunderstood and potentially benevolent economic force is only partially true. Supporters of this theory often cite research from the Federal Reserve Bank of Minneapolis, which showed that falling prices seldom coincide with depression.

Looking at data for 17 countries over more than a century, the Minneapolis Fed concluded that "nearly 90 percent of the episodes with deflation did not have depression."

A swelling dollar can clearly be good news for shoppers as well as for those who are sitting on cash. Deflation is often a result of economic progress -- productivity improvements that increase spending power. This was the friendly species of deflation caused by surging Chinese output from the 1990s onwards.

The current variety of deflationary pressure is far less benign. It stems not from efficiency savings but rather from weak demand. Worse still, it is accompanied by record levels of debt.

Despite frantic efforts to pay off loans, household debt is still around 130 percent of disposable income. This was precisely the combination that Irving Fisher warned about in his celebrated 1933 article on debt deflation.

Under these conditions, the rising real value of debts encourages households and businesses to sell their assets to pay down loans. As fire sales reduce asset prices -- stocks and property -- real net worth declines further. Output and employment decline, accelerating the slide in prices.

To add to the pain, real interest rates increase whether central bankers like it or not, discouraging borrowing and promoting even more savings.

"The more debtors pay, the more they owe," Fisher wrote, since "the liquidation of debts cannot keep up with the fall of prices which it causes."

But with the U.S. economy clawing its way out of recession, surely the danger has passed? Not quite. Prices are the ultimate economic straggler.

In Japan, for example, the country only started to experience falling prices roughly three years after the start of the recession in 1991. Wages didn't start to fall until 1997. The United States could still follow Japan's lead.

Downward pressures on prices in the United States continue to intensify, according to the latest research by Capital Economics. Core inflation may have held at a respectable 1.5 percent, but this is deceptive. U.S. goods inflation has defied gravity in part because of hefty increases in tobacco taxes over the past six months. A 28 percent increase in tobacco prices from a year ago is adding one percent to core goods inflation, according to Paul Ashworth of Capital Economics.

"Without this, core inflation would already be matching the lows reached at the end of 2003," he says. The tobacco effect will soon fade.

Services inflation, meanwhile, has been very weak. Here the key factor has been weak rental prices, which account for about 40 percent of the total core index. Unemployment and foreclosure will continue to put relentless downward pressure on rents. Already the rental vacancy rate is at a record 10.6 percent.

So we are right to be afraid of deflation -- very afraid. It still has the potential to sap energy from the American economy for years to come.

The Federal Reserve is preparing to lay down its unorthodox monetary policy instruments. But it may have to dig deep into its tool box before too long if deflation takes hold.

By John M. Berry

Financial crises and the policies to deal with them top the agenda at the Kansas City Fed's Jackson Hole conference. But what is actually going to be on everyone's mind at the august gathering is the uncertain future of the Federal Reserve itself.

Many members of Congress want to clip the Fed's wings for failing to prevent the crisis and for its actions since the meltdown began two years ago. In particular, most are angry about government bailouts, starting with the $29 billion in Fed backing for the purchase of Bear Stearns by JPMorgan Chase.

Financial institutions got into trouble because they took enormous risks, and the public bailouts look suspiciously like unjustified rewards for fat cats' wildly reckless behavior. But the bailouts were an unavoidable cost of halting the country's plunge into a second Great Depression. Congress has got to swallow its anger and do what is needed for the future.

The first objective on the financial reform agenda when Congress reconvenes next month should be to do no harm. That means killing legislation that would direct the Government Accountability Office to "audit" the Fed's monetary policy actions. Such audits could allow politicians to influence those decisions, which is exactly what some of the bill's sponsors want.

Angry as they may be at the central bank right now, members of Congress would surely rue the day they had to deal directly with raising interest rates -- a step that will inevitably be needed at some point to curb inflation and keep the economy on an even keel.

Whatever else the role of the Fed is to be, its monetary policy independence should be preserved as it pursues its twin mandates of stable prices and maximum sustainable employment. And Fed officials need to be insulated from political pressures.

In return for that insulation, the Fed has become ever more open and accountable. Since 1994, the central bank has started announcing policy changes as soon as they are made, quickly publishing detailed minutes of policymaking meetings, and releasing transcripts after a five-year lag. It also now makes public details of the long-term forecasts of its top officials.

The second Fed role that must be preserved in the national interest is that of lender of last resort to financial institutions. Solvent banks that get squeezed for cash must be able to borrow directly from the central bank to prevent a failure that could trigger a collapse of other institutions.

Of course, the Fed, led by Ben Bernanke, went far beyond that traditional lending role last year. Citing legal authority not used since the 1930s, it loaned money not just to banks but to brokers, investment banks and insurance companies. And when that failed to stabilize money markets, it risked hundreds of billions of dollars of taxpayer money to buy mortgage-backed securities and other private credit instruments to make credit more available to businesses and households.

Bernanke and other Fed officials were uncomfortable extending credit in these unusual ways, which really ought to have been the Treasury's responsibility. But, objectionable as they were to many members of Congress and to a number of economists, these measures have proved essential. In any case, the Treasury Department did not have the money or the authority to act. To settle this for the future, Treasury should be granted both under the financial system overhaul.

There is also plenty of opposition to the administration's proposal to give the Fed broad oversight of financial markets as a regulator of systemic risk. The crisis has demonstrated that such a regulator is badly needed, and the Fed should win this one by default. Despite the central bank's failure to head off the crisis, there is simply no other agency -- not the Securities and Exchange Commission, the Federal Deposit Insurance Corp, the Comptroller of the Currency or any other -- capable of doing the job.

As for the remaining key issue, consumer protection, Bernanke should cede responsibility for truth-in-lending and all related activities to the new consumer agency proposed by the administration. If he does that, the Fed will be more likely to keep the powers it really needs.

Even so, I think it's a shame that the Fed didn't follow the Bank of England's lead in extending asset purchases. If the Fed is so confident that it can quickly suck back any liquidity then why not try to make sure the recovery gets off to a stronger start?

The economic revival will soon start to look quite statistically impressive, with growth rates of up to 3 percent. Beneath this there will be climbing unemployment and surging foreclosures. The Fed itself is forecasting tepid growth and mounting joblessness. They could still help ease this pain by striving to shave more off the cost of borrowing for consumers and businesses.

They have done a great job at helping save America from depression. But this is a limp end to a historic policy.