From Bloomberg: Bernanke May Run Low on `Ammunition' for Loans, Rates (hat tip jsdg)
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. The central bank has cut short-term rates by 2.25 percentage points since September and will probably reduce them again tomorrow.These are two separate issues. The Fed isn't constrained by their balance sheet; they can just keep on lending. My understanding is their balance sheet limits the amount of sterilized lending (non-inflationary); further lending would increase the money supply and be inflationary.
On interest rates, the Fed is clearly running out of ammunition, and the street is expecting another rate cut today of between 50 bps and 100 bps. This raises the question of a liquidity trap (see Krugman: How close are we to a liquidity trap?). For those that want to understand the Japanese experience, I recommend a series of articles written by Professor Krugman in the '90s (those with asterisks are technical for all you Econ UberNerds!)
OK, some people might be asking what is sterilization? Sterilization means intervention that does not increase the money supply, like exchanging treasuries for mortgage backed securities (MBS). Say a bank needs cash, it puts up MBS as collateral (the Fed doesn't actually swap ownership), and the Fed loans the bank treasuries (that they are holding on their balance sheet). The bank can sell the treasuries, and raise cash, but the money supply doesn't increase.