The pedal is to the metal of the machinery of monetary policy. The Federal Reserve’s policy rate is near zero, it has poured more than $800 billion of reserves into the banking system, and its balance sheet has mushroomed to $2.25 trillion. These actions have shown that the Fed has wide latitude in managing the size and composition of its balance sheet and that its officials are willing to be aggressive in using that latitude.

Given the dire condition of financial markets and the economy, such flexibility has provided welcome stimulus. But the foreign exchange value of the dollar and longer-term capital values will ultimately depend on the Fed being symmetric in this aggressiveness–If the Fed does not unwind this accommodation when the economy improves, its policy setting will be wrongly positioned and inflation will result.

No doubt, Fed officials view this as a calculated risk. In the near term, the economy is performing poorly, and there is a chance that deflation will set in. Were prices to start falling consistently, interest rates would rise in real terms, throttling business spending, and consumers might defer spending even more than they have already. At that point, the Fed still has policy options, but they are untested. So, policymakers are accepting a risk that they understand–future inflation–to limit a risk about which they have no experience–deflation in the near term.

Policymakers’ success in paring back the balance sheet as markets improve and the economy rebounds depends in part on who will be in charge. Market participants might trust Fed Chairman Ben Bernanke to unwind Fed accommodation in time, but will he be in office after January 31, 2010, when his four-year term expires? Whoever is in the job will have to reduce the amount of reserves in the banking system. This can be done either by running off assets or by having the Treasury sell debt and build up its Fed balance.

Policymakers’ success in paring back the balance sheet as markets improve and the economy rebounds depends in part on who will be in charge.

As for selling assets, the Fed has a complicated balance sheet with various exposures to the private sector. Having been sensitized by recent events to the potency of the Fed’s powers, an interventionist Congress and administration may want it to go slow or even to accumulate more assets of favored industries. As for building up the Treasury balance, the government debt will be ballooning given the coming fiscal stimulus package, likely additional financial rescues, and the certain falloff in revenues as the economy contracts. In such circumstances, there will be limited appetite in Washington to add to this massive issuance of debt just to solve the Fed’s problem.

The possibility that politics will intrude to prevent an appropriate policy reversal in the future leaves us two choices. We can surrender to cynicism and circumscribe current policy action (that is, because the Fed might not be able to do the right thing in the future, it should not do the right thing now); A more enlightened alternative would be to create the institutional safeguards today that permit the correct policy tomorrow.

First, the Congress and the administration can depersonalize monetary policy so as to make the choice of Fed chairman less crucial. That can be done by giving the Federal Reserve an inflation goal. Right now, with inflation falling to the point when deflation looms, the direction to achieve a given inflation goal would signal political leaders’ desire for monetary accommodation. But it also will signal support to reverse that accommodation when the time comes.

Second, the Congress and the administration can delimit the Fed’s ability to hold risky assets that could put taxpayer funds in jeopardy. The balance sheet of the nation’s central bank is no place to hide assets. Crisis management might require the Fed to lend to private entities or to buy assets with credit risk in the heat of the moment. But the longer those assets sit on its balance sheet, the less it will be for crisis prevention and the more it will be about providing support for specific firms or markets. Legislation could require any private assets held by the Fed for two years to be funded by Treasury deposits.

If the Treasury is so willing to issue securities and build up its Fed balance, it will implicitly show its approval for the Fed’s taking on credit risk. If the appropriate officials at the Treasury are unwilling to show such approval, then the Fed has no business holding such risky paper.

Neither an inflation goal nor portfolio holding limits would constrain the current conduct of policy. Rather, they would help to define better the Fed’s purpose in setting policy and its accountability. Indeed, such provisions may make the Fed perform its stabilizing role more effectively in the near term by removing investors’ doubts that monetary policy might go off the rails.

In that regard, President Obama would be well served by talking with the United Kingdom’s former Prime Minister Tony Blair or current Prime Minister Gordon Brown about the benefits of preemptive action to strengthen the central bank. Among the first actions those Labour Party leaders took when gaining power in 1997 was to make the Bank of England independent in its policy setting and accountable for achieving an inflation goal. They understood the importance of establishing precedents that would blunt investors’ mistrust and thereby gain running room for other policy initiatives.

Vincent Reinhart is a resident scholar at the American Enterprise Institute. He is the former director of monetary affairs at the Federal Reserve Board and secretary of the Federal Open Market Committee.

Image by Darren Wamboldt/the Bergman Group.