Most of the financial news today is buzzing about the Dow’s 200+ point jump to open trading Tuesday, and attributing it to better-than-expected results from both Goldman Sachs and Lehman Brothers. Sources that have spoken with Housing Wire this morning, however, suggested that the market rally is much more likely due to strong expectations of a full percentage point cut to the Federal funds target rate later this afternoon. Bloomberg reports on Wall Street’s expectations:

Traders predict the Federal Open Market Committee, meeting today in Washington, will lower the overnight lending rate by a full percentage point or more, based on futures prices in Chicago. That would be the biggest reduction since 1984, when Paul Volcker led the central bank, and would bring the benchmark rate down to 2 percent.

Expectations as this story was written are even suggesting that a cut of 1.25 percent may be possible, based on a look at current futures. Should the Fed fail to deliver on the baseline one percent expectation, however, look for the market rally to quickly and drastically change course. That’s the interesting thing about expectations — just last week, most were considering a 50 bps cut to be in the bag and stopping there. But that was before the Bear Stearns fiasco. Before we stared down the meltdown. Now, the market wants monetary policy to match the liquidity program that has been put into place — in a word, aggressive. And that has at least some wondering if the Fed is running low on ammunition. A story on Bloomberg, published Monday, suggested that the Fed may soon have to start outright purchases of private-party mortgage backed securities, given that there isn’t much remaining wiggle room on interest rates. As the conundrum now facing the Fed has become clearer, the Calculated Risk blog wondered aloud about the resulting potential for a liquidity trap:

On interest rates, the Fed is clearly running out of ammunition, and the Street is expecting another rate cut tomorrow of between 50 bps and 100 bps. This raises the question of a liquidity trap …

Paul Krugman, a well-known economist and columnist at the New York Times, also suggested yesterday that the Fed could find itself dangerously close to “a situation in which conventional monetary policy loses all traction.” One source that spoke with Housing Wire said the Fed may be stuck. “If they deliver that full percentage point, they’ve really got nothing left in the tank,” said the source, who asked not to be named. “But if they don’t deliver, the market flips and we’ll go back to the drawing board on the issue of liquidity.” Senator Christopher Dodd (D-Conn.) echoed similar fears that the Fed won’t be able to go it alone for much longer. “While the Federal Reserve has acted boldly, the agency is rapidly exhausting the weapons in its arsenal,” he said in a statement on Tuesday. “It is time for the Administration to embrace a more comprehensive, bold, and effective approach that goes to the heart of the current financial crisis – the mortgage markets.”

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