MARTHA'S VINEYARD, Mass. (

TheStreet

) --

Federal Reserve

Chairman Ben Bernanke proved his mettle in the first term by saving the banking sector from collapse. The test of his second term will be whether he can help it fully recover.

Bernanke achieved a remarkable feat on Tuesday as President Obama touted his accomplishments and

kept him

at the head of the Fed. Obama is arguably on the opposite side of the political spectrum as a progressive, liberal-minded Democrat. Bernanke, a registered Republican, was appointed in 2006 by conservative GOP President George W. Bush.

Yet Obama cited Bernanke's "background, his temperament, his courage, and his creativity" as reasons for his reappointment, noting that the Fed chief's "bold action and outside-the-box thinking" helped prevent an economic catastrophe.

This would not happen in ordinary times, but these aren't ordinary times. Bernanke's scholarly pursuits at Princeton have made him perhaps the foremost expert on the Great Depression. During the worst financial crisis since the 1930s, he's not a bad guy to have at the helm, regardless of political stripe.

"He's not worried about his job -- not sure he ever was worried about his job," says Roger Young, a portfolio manager for Miller/Howard Investments, who invests in banks. "But the timing of this is wonderful, and in that sense, it removes some -- not all -- of the politics from some tough decisions yet to be made by the Fed."

The toughest of those decisions will be when to raise rates.

The Federal Reserve has taken unprecedented measures under Bernanke's watch during the Great Recession, which officially kicked off in December 2008. Troubled banks can now borrow money for nothing, and use an assortment of nontraditional, and sometimes risky, assets as collateral -- from Treasury bills and

Fannie

/

Freddie

notes to mortgage-backed securities and credit-card receivables. In consumer terms, it's sort of like walking into a local bank branch while on unemployment, and receiving a $5,000 loan with little to no interest payments. If you default, the bank has the right to seize your nicked up 1995 Toyota Corolla, shoddy transmission and all.

Bernanke's policies have expanded the Fed's balance sheet enormously, including the addition of $61.7 billion in toxic assets extracted from Bear Stearns and

American International Group

(AIG) - Get Report

. The policies have also allowed megabanks like

Bank of America

(BAC) - Get Report

,

JPMorgan Chase

(JPM) - Get Report

,

TheStreet Recommends

Wells Fargo

(WFC) - Get Report

and

Citigroup

(C) - Get Report

to keep their heads above water. One-time investment banks

Goldman Sachs

(GS) - Get Report

and

Morgan Stanley

(MS) - Get Report

converted to bank holding companies to do the same after Bear Stearns and Lehman crumbled, and

Merrill Lynch

fell into BofA's arms as borrowing and lending were crippled at the height of the credit crisis last year.

As banks started posting seam-splitting profits in the first two quarters, the economy began its own timid recovery. Bernanke's political counterparts have pilloried banks for hoarding bailout cash, and for hiking rates on consumers and businesses while enjoying the Fed's free money. However, the real economy lags policy implementation by up to a year, meaning that whatever Bernanke does now won't affect Main Street for quite some time, and what he did in late-2008 is starting to work today.

His next challenge will be the big shock that sent consumers into hiding last summer: inflation.

When rates are low for too long and too much money is floating around, prices surge higher. While the Fed and Treasury have injected lots of new dollars into the system, that is not yet the case; prices are down 2.1% over the past year, the sharpest deflation in more than half a century. Still, worries abound.

Investors, ever forward-looking, are flustered about when the Fed will begin raising rates. The stock and bond markets become jittery ahead of FOMC announcements regarding rate policy, and the futures market's implied probability of a rate hike has climbed steadily since early June.

In a

Wall Street Journal

op-ed on July 21, Bernanke said that its current strategy "will likely be warranted for an extended period" -- a view reiterated by the Fed earlier this month when announcing that its interest rate target will remain at 0% to 0.25%. The Fed also extended its special TALF lending program for six months for some types of collateral, and a year for other types.

However, Bernanke also said in his op-ed that the period of "accommodative policies" will end when "economic recovery takes hold." On Friday, he indicated that this has started to occur by saying the prospects for near-term economic growth "appear good" -- what many took to be an official statement that the recession has ended.

Once that recovery begins to take shape, the Fed must set interest-rate policy that fosters growth, but doesn't allow it to get out of control. It must also restore its balance sheet in due course. Banks are most immediately vulnerable to whatever policy is set.

According to a study by the Cleveland Fed, inflation has a "peculiar" effect on the financial sector. It lowers the "real" rate of return on assets, thus discouraging saving and encouraging borrowing. But it also causes banks to pull back on borrowing and lending because it is too costly and risky. This, in turn, stifles economic activity anew.

The timing of rate hikes will be key to avoiding such a scenario. That task -- along with deleveraging the Fed's newly expanded balance sheet -- is complex, predictive and challenging. But the market seems to have faith in Bernanke, who built his reputation as a strong, creative leader of the U.S. central bank under intense fire.

"He's been highly creative, willing to try new things and if they don't work, willing to go onto something new," says William Isaac, former FDIC chairman and a managing director at the consulting group LECG.

Isaac says he and his banking associates considered former Treasury Secretary Henry Paulson less capable of handling the escalating financial problems last year. They "took comfort" only when Bernanke began "taking a stand and doing things on his own" rather than being deferential to other regulators.

"I think most of the bankers would believe he's been a bright spot in an otherwise gloomy scene," says Isaac. "

Bernanke grew into the job very quickly under a lot of fire. But once he started taking hold and providing the leadership, I believe this crisis started to turn around."

Written by Lauren Tara LaCapra in New York