Coming Week: Bear(s) Set Agenda

After propping up Bear Stearns (BSC Quote) with emergency cash last week, the Federal Reserve will now attempt to rescue the U.S. financial system with more interest rate cuts aimed at shaking the credit markets out of a fear-induced paralysis.

The Fed, set to meet and unveil fresh cuts to its short-term rate target on Tuesday, needs investors to start trading mortgage-backed securities again or the U.S. economy could be facing a calamity of unprecedented proportions.

The central bank has already gone to extraordinary lengths to inject fresh liquidity into the markets, but so far, it has been unable to achieve its aim.

"The Fed is providing liquidity, but you still have to have buyers and sellers to match trades to revive the markets," says Paul Mendelsohn, chief investment strategist with Windham Financial Markets. "The problem is that you have sellers but you've got no buyers. The market is totally shut down. This is a potential systemic problem for the system. There's got to be other people having problems here if Bear Stearns is having problems here."

On Friday, Bear Stearns revealed that JPMorgan Chase (JPM Quote) was acting as a conduit for the Fed by borrowing emergency funds from its so-called discount window and relending them to the bank for 28 days so it could meet its obligations.

Loaded with mortgage-backed securities that are being spurned by investors amid the steepest declines in the U.S. housing market since the Great Depression, Bear Stearns said its "liquidity position in the last 24 hours had significantly deteriorated" amid rumors of a cash crunch. The investment bank's stock crashed 47%. Its desperate circumstances echoed earlier news that a big fund managed by the Carlyle Group, an elite private equity firm, was facing collapse.

Four days earlier, Bear Stearns CEO Alan Schwartz appeared on CNBC and said the bank's "balance sheet, liquidity and capital remain strong." The sudden reversal reflects a market gripped by panic, and it only reinforced a mass loss of confidence that is spreading. Unless the Fed can stabilize financial markets, former Fed governor Lyle Gramley says more such disasters may be in store.

"We're in a situation now where, unlike previous recessions, pushing down on the monetary accelerator by the Fed doesn't seem to be working," says Gramley. "We're in a situation where we have to anticipate that the unemployment rate is going to go up, foreclosures are going to increase and home prices are going to continue under downward pressure. If the Fed is unable to turn this situation around, then we could be in quite a dire situation."

Gramley says other forms of government intervention will soon be necessary.

"The Fed can't bail out a bank -- certainly not an investment bank," he says. "If those institutions are going to be bailed out, it has to be something cooked up by the federal government. We have to be thinking outside the box about innovative ways we can deal with this situation. Because it's unlike anything I've ever seen before, and it poses some very serious risks to the economy."