Market Awaits More Fed Rate Cuts

Updated from March 17

The Federal Reserve is expected to announce more cuts to its key interest rate target Tuesday, one day after the central bank managed to stabilize the stock market as investors struggled to comprehend the stunning collapse of a major Wall Street investment bank.

The Fed, with the help of JPMorgan Chase(JPM Quote), helped Bear Stearns (BSC Quote) avoid bankruptcy over the weekend and helped inject liquidity to seized credit markets by allowing investment banks to borrow direct funds in a historic break with nearly a century of policy.

Now, investors are betting that the Fed will slash its federal funds rate target by a full percentage point, from 3% to 2%. Having already slashed 225 basis points from the target since the credit crisis emerged last summer, some observers are wondering if it can ever restore confidence to financial markets with monetary policy, but Wall Street is clamoring for the Fed to try.

"This is like treating a patient that has a gunshot wound," says Ethan Harris, senior economist with Lehman Brothers, "You have to go all out to save the patient. Whether or not the patient could survive without the Fed, I'm not sure."

The Fed's aggressive tactics in aiding Wall Street during this crisis face withering scrutiny from critics who see its willingness to bail out Bear Stearns and other investors as a move that will distort incentives by tinkering with the free markets.

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"It is remarkable to see a group of individuals who claim to be believers and advocates of free markets cower at the mere thought of markets setting their own course," said Mike O'Rourke, chief market strategist with BTIG-Bass Trading. "The conversation should not be centered around the fear of disappointing the markets, it should be centered around the fear of the market itself. Fear of the market is healthy. It's what keeps investors from leveraging 32 to 1."

Treasury Secretary Henry Paulson said at a press conference Monday that the "moral hazard" implications of the Fed's bailout for Bear Stearns, which helped it avoid bankruptcy, were mitigated by the colossal losses suffered by the investment bank's shareholders over the last week.

"Our priority is to provide stability for our financial markets," said Paulson.

The rate odds for a 100-basis point cut spiked from just 52% on Friday, after Bear Stearns -- trading at close to $80 a share at the beginning of this month -- was acquired in a fire sale for a stunning $2 a share by JPMorgan, with $30 billion in emergency funds provided by the Fed.

Despite all that cash, Bear Stearns cost a measly $260.5 million. Now, rumors are spreading that other investment banks -- like Lehman Brothers(LEH Quote) -- are experiencing liquidity problems. Investment banks and other financial institutions are loaded with mortgage-backed securities whose value are a mystery amid historic declines in the U.S. housing market and spiking mortgage delinquencies and foreclosures on markets around the country.

Meanwhile, the Fed's critics point to the value of the U.S. dollar, which is plunging against foreign currencies as the central bank pumps fresh liquidity into the financial markets, tempting inflationary pressures.