Having already bailed out the financial system with its rescue of

Bear Stearns

( BSC) last month, the

Federal Reserve

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is under pressure to expand its extraordinary encroachment into the markets even further as the credit crisis persists.

But as the Fed wrestles with how best to guide the economy through the credit crunch, calls for a fiscal response from elected officials are growing. While the Fed has not pledged to backstop the flagging mortgage market,

The Wall Street Journal

reported Wednesday that internal discussions are already under way at the central bank about contingency plans for expanding its lending power should the crisis continue and get worse.

"It would be a big mistake for the Fed to backstop the mortgage market," says Nouriel Roubini, an economics professor at New York University and chairman of RGE Monitor. "It's a case for fiscal policy to consider whether to nationalize a big chunk of mortgages. There likely would be a huge fiscal cost to this, so it's an issue of spending and taxation, and having the Fed do that is inappropriate and reckless."

First Recession, Then Regulation

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On Tuesday, the Fed

released the minutes

from its March meeting, which was held just days after Bear Stearns, the fifth largest U.S. investment bank, notified the central bank that its liquidity position was eroding and it was on the verge of bankruptcy. In response, the Fed backstopped nearly $30 billion of Bear's riskiest mortgage-related securities to orchestrate a swift acquisition of the bank by

JPMorgan Chase

(JPM) - Get Report

for a stunning $2 a share, a controversial price that was later renegotiated up to $10 a share.

In recent congressional testimony, Fed Chairman Ben Bernanke

justified

the action as a defense against a systemic unraveling of the financial system that Bear's bankruptcy could have triggered. He disputed the view that his actions surrounding Bear amounted to a government bailout for the investment bank but also allowed that they could be interpreted as a bailout for the U.S. financial system.

That led lawmakers to question why the government should rescue Wall Street in order to help the economy without rescuing the growing mass of homeowners facing mortgage foreclosures for the same reason. The Bush administration has taken steps to reduce mortgage burdens for some homeowners, but Democrats are claiming that a much broader and more aggressive effort is needed, particularly in light of the sketchy lending practices that proliferated as the housing bubble grew.

The Fed minutes painted a gloomy picture for economic trends in the U.S., and while the central bankers reiterated their forecast for an economic recovery in the second half of 2008, they also said that "considerable uncertainty" surrounded the forecast, with risks to the downside. They also acknowledged the potential for a deep and prolonged downturn in the economy.

On Wednesday, the

Journal

reported the Bush administration

is exploring a plan

would help 100,000 homeowners reduce their monthly mortgage payments. Lenders and investors would be asked to write down the value of the mortgages and the federal government, through the Federal Housing Administration, would assume the risk of default.

The plan amounts to a smaller-scale version of a competing plan being pushed by Rep. Barney Frank (D., Mass.), the House Financial Services Committee chairman, that would have the FHA insure up to $300 billion in restructured loans for homeowners facing foreclosure.

Roubini favors Frank's plan.

"Until you buy the mortgages, reduce their face values and refinance people with fixed rates and a lower principal, you're not going to remedy the problems in the financial market," he says. "You have to reduce the face value of the debts outstanding, and someone is going to have to take losses."

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) and

Freddie Mac

( FRE), 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.