Fed Weighs Options as Credit Crunch Lingers

While the partisans on Capitol Hill haggle over their plans, the Fed is left to ponder the extent of its own powers, should more Bear-like emergencies arise. Before the credit crunch began last summer, the Fed had $790 billion in Treasury securities on its balance sheet. Since then, it has committed to sell or lend $300 billion of that, leaving the central bank with more breathing room on its balance sheet but not a limitless capacity to expand its lending.

Some investors have called on the Fed to buy mortgage-backed securities outright in the market to dislodge the fear that has frozen the nation's credit markets. The central bank used to buy securities issued by government sponsored mortgage giants Fannie Mae(FNM Quote) and Freddie Mac(FRE Quote), a practice that was ended by Fed Chairman Paul Volcker in the 1980s.

"They could start doing it again, and it may come to that," says Joseph Lavorgna, U.S. economist with Deustche Bank.

So far, the Fed has resisted calls for such an expansion of its role, but with its fed funds rate at 2.25% -- down 3 full percentage points since September -- and the extra room on its balance sheet shrinking, the central bank may soon feel pressure to get more creative. Meanwhile, it faces inflation concerns, and some observers question whether lower interest rates are the right prescription for an ailment that was caused, in part, by lower interest rates in the first place.

While former Fed Chairman Alan Greenspan was out defending his role in the overseeing the credit bubble earlier this decade at various media outlets on Tuesday, Volcker voiced rare criticisms of current Fed policies in a speech at the New York Economic Club.

"What appears to be in substance a direct transfer of mortgage and mortgage-backed securities of questionable pedigree from an investment bank to the Federal Reserve seems to test the time-honored central bank mantra in time of crisis: lend freely at high rates against good collateral; test it to the point of no return,'' said Volcker, according to media reports. "The implications of these decisions, and the lessons from the unfolding crisis itself, surely deserve full debate and legislative review in the period ahead."

Volcker also took aim at the explosion of complex derivative securities in the modern financial system that was championed by Greenspan.

"The bright new financial system, with all its talented participants, with all its rich rewards, has failed the test of the marketplace," he said.