If not, there is always the Fed funds rate to cut [today]. The Fed will almost surely lower short-term rates again this week from 3% to something like 2.5% or even 2.25%. Keep in mind this puts real U.S. interest rates below the rate of inflation. Negative real rates are obviously inflationary.

But here’s the other thing. If the current liquidity crisis spreads beyond Bear Stearns, the Fed will be compelled to make all of its US$700 billion in Treasury assets exchangeable to distressed firms. It has said as much in accepting a “broad range of collateral” it is willing to accept in exchange for short-term funds. Once the Fed depletes or exhausts its inventory of Treasuries it can swap for illiquid assets, what does it do?

It has to go out and buy more Treasuries on the open market. And to do that it WILL need to create new cash, which is definitely inflationary. The Fed hasn’t yet monetized bad mortgage debt by creating new cash to buy it from banks. Instead, it’s trading good debt for bad debt.

We reckon – the way this thing is playing out – that the Fed is going to have print more money soon. It will either print more money to buy more Treasuries to lend to illiquid, poorly capitalized financial institutions (Fannie Mae and Freddie Mac come to mind).

Or, if things really get desperate, the Fed will have to create new cash to directly purchase impaired assets from financial institutions. This is why it’s called “monetizing debt” by the way. The central banks turn liabilities into cash by printing new money to buy the debt from its current owners.

This kind of deal bails out the owners of the bad debt (the investment banks and mortgage lenders). It keeps the financial system alive. It prevents the further sale of assets and the loss of depositor’s money. And it prevents a complete collapse of confidence in the financial sector, as happened in the Great Depression. But it does it all at a great cost: the viability of the U.S. dollar as the world’s reserve currency.

So, the Fed’s liquidity efforts will become truly inflationary when it runs out of Treasury bonds to exchange for dodgy mortgage collateral. There is an interesting argument to be had over whether the new dodgy collateral becomes the backing for the U.S. dollar. But we will leave that aside. We wonder today how many bullets the Fed has left in its monetary policy gun.

“The Fed has committed as much as 60 percent of the $709 billion in Treasury securities on its balance sheet to providing liquidity and opened the door to more with yesterday’s decision to become a lender of last resort for the biggest Wall Street dealers,” reports Scott Lanman at Bloomberg.

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