The downfall of Stan O’Neal as chief executive of Merrill Lynch is a useful corrective to the popular idea that the US Federal Reserve has been running monetary policy of late as a kind of lifeboat to preserve the jobs of wealthy bankers.

The swift and unforgiving humiliation for one of Wall Street’s highest flyers in the wake of the investment bank’s eyewatering $8 billion loss announced last week, is an encouraging indication in fact that markets still work.

Urgent interest-rate cuts by the US central bank in the past three months were never going to save Mr O’Neal from the consequences of Merrill’s disastrously foolhardy plunge into the sub-prime mortgage frenzy of the past few years. Now it is true that Mr O’Neal’s expected multi-multimillion-dollar golden handshake is the kind of punishment we would all like when we screw up. But for Masters of the Universe - especially for those like the famously aloof and authoritarian Mr O’Neal – the pain of public failure is a more powerful sanction.

Indeed if there is anything useful to come out of the US sub-prime debacle it is that men such as Mr O’Neal and Chuck Prince, his counterpart at Citigroup, who is yet to fall on the sword that has been carefully positioned under him, are starting to be held accountable for the mess they have got us all in.

Others may be luckier and survive. But even for them, and certainly for the next generation of financial bosses, the fate of Mr O’Neal should have an effect similar to the one Voltaire’s Candide noted could be achieved from the occasional execution of a British admiral.

Of course this does not quite get the authorities completely off the moral hazard hook. Executing chief executives is one thing; limiting the losses of investors in their banks is another. The super-fund established two weeks ago by Hank Paulson, the Treasury Secretary, to buy up asset-backed securities from troubled institutions still has a nasty stench.

For the Fed, however, the calculation is different. Its interest-rate cuts may soften the blow of financial retribution for some irresponsible investors. But in the current US economic circumstances, it now clearly has no alternative.

The central bank seems very likely to cut rates again this week when its policymaking committee meets today and tomorrow. Markets expect a 25 basis-point cut in the federal funds rate to 4.5 per cent after last month’s surprise 50 basis-point cut. It might choose to blindside us again and do another half-point cut, but I doubt it. One surprise is a welcome boost. Two looks like panic.

Nonetheless, the Fed seems to be well into a cycle of easing now as the US turbulence continues. A few weeks ago investors were wondering whether the dramatic rate cut last month might be the last. This was always improbable. Even if the easing had been designed solely to get the US through the short-term credit squeeze, it is unlikely one quick rate cut would have been enough.

But it is now clear that the Fed is primarily focused not on the immediate financial stress but on the broader effect of a serious downturn in the US housing market.

As they weigh their decision-making, Fed officials are trying to gauge the appropriate stance of monetary policy in what promises to be a turbulent period for the world’s largest economy. Even after last month’s rate cut, at 4.75 per cent the Fed funds rate is still well above a neutral policymaking level.

Current economic models suggest the equilibrium real interest rate – the rate which is neither stimulating nor restraining the economy - is probably around 2 per cent. With inflation a little over 2 per cent that means the current Fed funds rate is still squeezing demand.

Given the outlook for the US economy in the next six months it is hard to justify that kind of stance. The big worry is whether the American consumer – the hero of the global economy for the past fifteen years – might finally be about to call it a day. With house prices falling and mortgage rates for many borrowers still rising, and the job market looking a little soft, consumer confidence is on the slide. If that translates into retrenchment in the shops, the immediate future is grim. Getting interest rates down to levels that are likely to stimulate spending is therefore the key priority for the Fed.

But what about all those inflation pressures, you ask – a slumping dollar and oil edging closer to $100 a barrel? As long as rising petrol and home heating costs and higher prices for imports do not bury themselves in general consumer expectations for prices, the inflationary threat remains contained, in most Fed policymakers’ view.

In any case, given the alternative – an unpleasant recession – a little bit of inflation, like a little bit of help for irresponsible investors, is a necessary evil these days. Now if there was a way to punish inflation the way Merrill Lynch punished Stan O’Neal, we might really have achieved something.

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