Former Fed chief Paul Volcker has warned that the Fed’s recent use of “long-dormant” powers may set a dangerous precedent for the future, causing “market participants” to factor another Fed bailout into their increasingly reckless trading strategies.

“Whatever claims might be made about the uniqueness of current circumstances, it seems inevitable that the nature of the Fed’s response will be taken into account and be anticipated, by officials and market participants alike, in similar future circumstances,” Volcker said in prepared testimony before Congress.

This from The Wall Street Journal:

Volcker hinted at the Fed’s recent role facilitating the rescue and proposed takeover of Bear Stearns by J.P. Morgan Chase. The Fed, he said, “felt it necessary to extend that safety net” to systemically important institutions by “providing direct support for one important investment bank experiencing a devastating run, and then potentially extending such support to other investment banks that appeared vulnerable [to] speculative attack,” Volcker said.

“Hence, the natural corollary is that systemically important investment banks should be regulated and supervised along at least the basic lines appropriate for commercial banks that they closely resemble in key respects,” he said.

Still, he stopped short of criticizing the Fed’s response to the Bear Stearns collapse. “I can understand why they felt they had to act,” Volcker said.

He said heavily “engineered” financial markets, using sophisticated mathematical models, led to “enormous complexity” and “opaqueness” in markets.

“Volcker cast out the devil of inflation during his term [as head of the Fed],” says Bill Bonner in The Daily Reckoning.

“Thus interest rates could come down. Thus, began a quarter century of falling interest rates and increasingly accessible credit. This eventually produced the absurd and pernicious consequences we describe here in the Daily Reckoning. Just as teenaged kissing leads to petting…which leads to…well, you know how it works, dear reader…success leads to complacency which leads to excess. But the long bull market in bonds (bonds go up when interest rates go down) also vastly increased the supply of capital available for new industries…and caused an explosion in output capacity.”