NEW YORK (Fortune) -- It may be the most important development to emerge from the recent market turbulence: The Federal Reserve, under Chairman Ben Bernanke, is going back to being a central bank.
Judging by its cautious and finely-calibrated responses through a very ugly August, the Fed appears keen to put the Alan Greenspan years firmly in the past and take a much more orthodox approach to monetary policy. While the Fed will probably cut interest rates as early as next month, its behavior in August strongly suggests that Bernanke will avoid using interest rates to deliberately spark big increases in lending, the high risk strategy pursued by Greenspan from 2001 to 2004.
"I think Greenspan would have cut rates already. So I do think things are beginning to look different at the Fed," says Paul Kasriel, economist at Northern Trust.
A change at the Fed would have far-reaching consequences for the U.S. economy and the stock market. Initially, a much less accommodating Fed will be perceived as a reason for bearishness. But, over the longer term, market players may well see a less dysfunctional central bank as a good thing that could begin the process of cutting borrowing levels in the U.S., something that has to happen if the American economy is not going to seize up every time interest rates rise.
So what is the actual evidence that Bernanke, who helped formulate monetary policy under Greenspan, is not following the same approach as his predecessor? One huge change: Bernanke's actions have made it clear that he won't be panicked into cutting its key interest rate - the Federal funds target rate - when markets get mauled.
True, Greenspan often said that a central bank should cut rates chiefly in response to weakness on Main Street, not Wall Street -- the same message that is coming out of the Fed at the moment. But from 1998 onward, Greenspan's actions were very much at odds with that position. In that year, the Fed slashed rates in response to market turbulence sparked by the collapse of a large hedge fund and devaluation of the Russian ruble.
Current market conditions are worse than in 1998 and this Fed has cut only the discount rate, a move designed to get healthy financial institutions trading with, and lending to, each other. Critically, Bernanke's Fed hasn't yet reduced the Fed funds rate, which does have a big impact on the economy. And it has not officially commented on what its next moves might be with that rate.
And if it does lower the Federal funds rate next month, it's hard to see it rushing to further cuts, as happened in 1998. Why? Because there seems to be a recognition at the Fed that lending got out of hand in the past five years, and it's important now for markets to attach new, lower values to many loans and bonds.
In a June speech, Bernanke commented on the shake-out in subprime mortgages in a conspicuously neutral way, suggesting the Fed was monitoring housing problems, but was not unduly concerned by adjustments taking place in it. "I think the Fed is happy to see that risk aversion is increasing," says Kasriel.
Indeed, Jeffrey Lacker, president of the Richmond Federal Reserve Bank, made that point exactly in a speech Tuesday. While Lacker is not currently a member of the Fed committee that makes monetary policy, his views are almost certainly shared by some members of the committee. In an obvious nod to the cut the discount rate last week, Lacker argued that a reduction in a discount rate is a good thing to do because it can supply liquidity without leading the market to misprice credit once again. "Sound discount window policy, I believe, should aim at supplying adequate liquidity without undermining the market's assessment of risk," he stated.
While Treasury secretary Henry Paulson is not a Fed member, it was more than interesting to see him making the same point, also on Tuesday, when he said: "As the Fed addresses liquidity this makes it possible, this makes it easier, for the market to focus on risk and pricing risk."
What seems so different under Bernanke is a genuine recognition that interest rate cuts could spark another bubble, and thus must be enacted carefully. This appears to have been a big factor in the Fed's decision-making last week. In a blow-by-blow account Monday of the Fed's internal discussions surrounding the cut in the discount rate, The Wall Street Journal wrote about this fear: "The [Fed] officials were looking for a maneuver dramatic enough to shore up confidence, while avoiding a cut in the Fed's main interest rate, the federal-funds rate. Mr. Bernanke was still not convinced the economy needed a cut, and some Fed officials feared it might encourage more of the sloppy lending that led to the crisis."
The stand-back strategy of Bernanke's Fed was in many ways vindicated by news Wednesday night that Bank of America is making a $2 billion investment in Countrywide, the large mortgage company that is suffering a liquidity squeeze. It shows that stronger firms are capable of becoming part of the market adjustment by making investments in weaker companies during this crisis. This happened without a cut in the Fed funds rate.
But if credit markets are in seizure, where might the next bubble be? Once markets settle down, a big drop in the Fed funds rate could, for example, spark a lending splurge by credit card and auto-finance companies, which currently have healthier balance sheets than mortgage lenders.
To be sure, more evidence is needed to make an open-and-shut case that the Fed has changed its spots. If weakness starts to show up in the real economy, the Fed could revert to the laxity of the Greenspan years in a flash. Bernanke is no Paul Volcker, whose anti-inflation bias led him to hike rates to recession-causing levels in the 1980s. However, Northern Trust's Kasriel does think the Fed would tolerate some economic sluggishness if it brings some stability back into the economy. "I don't think the Fed would welcome a recession, but I think it would be okay with some below potential growth," he says.
After nearly 20 years at the helm of the Fed, Greenspan left the U.S. economy more vulnerable to credit shocks than it has ever been. It will take Bernanke 20 years to undo that mess. And there's a good chance the clean up began last week. 
