The Federal Reserve has been a dominant force in the battle against financial chaos and the threat of depression, and Chairman Ben Bernanke has repeatedly assured the markets that the central bank “will not stand down” until these battles have been won.

In the process, the Fed has pushed conventional monetary policy to the limit, driving the federal funds rate essentially to zero and publicly committing to maintain that position for an extended period.

The Fed also has developed a range of policy innovations, including unconventional measures that employ the unlimited power of its balance sheet to maintain credit flows in sectors of the economy that need it the most — including the agency-related home mortgage market and the private asset-backed securities markets for consumer loans and commercial mortgage-backed securities.

Early signals of near-term economic stabilization have provoked speculation about a shift in Fed strategy — from an all-out war against financial market dislocations and economic weakness to a systematic march back toward monetary neutrality. Indeed, futures markets are signaling expectations of a higher federal funds rate by late this year, but the early stages of economic recovery are likely to be quite tenuous and the labor market is sure to deteriorate for some time beyond the trough in economic output.

We do not expect the Fed to raise the funds rate until the unemployment rate clearly is on a downward path, and that may not occur before the end of next year.

There’s also speculation that the Fed will have to rein in its balance sheet activities because of the inflationary consequences of its asset purchases and corresponding increases in the monetary base, the “high-powered” money. But, so far, these increases have flowed into excess reserve positions of commercial banks, with no immediate inflationary consequences.

In the event that banks come out of their shells and begin to supply ample credit to the private sector, the Fed will be able to quickly run down its balance sheet positions and extract excess reserve balances, as needed, to prevent an inflationary buildup.

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