The collapse of Lehman Brotheres (NYSE:LEH) has increased market expectations of a Fed rate cut – maybe even in today’s FMOC meeting. The Fed has already introduced emergency lending measures to boost liquidity in the banking system, and August’s negative CPI figure could be decisive. However, Money Morning’s William Patalon III says the desperate efforts of Wall Street and the Fed to stem the tide of financial woes may not be enough to save the US economy from a stagflationary recession.

Wall Street entered last weekend anticipating a government bailout of Lehman Brothers, but exited with Merrill Lynch (NYSE:MER) agreeing to sell itself to Bank of America (NYSE:BAC) for nearly $50 billion – and with Lehman announcing it will seek bankruptcy in a bid to avoid a total liquidation after it was unable to find a buyer.

“The tectonic plates beneath the world financial system are shifting, and there is going to be a new financial world order that will be born of this,” Peter Kenny, managing director at Knight Capital Group (NASDAQ:NITE), the New Jersey-based brokerage firm that handles $4 trillion in stock transactions a year, told Bloomberg. “It’s an ugly and painful process.”

Investors worldwide took a beating.

At yesterday’s close in New York, the blue-chip Dow was down 504.48 points, or 4.42%, to finish the session at 10,917.51. The tech-laden Nasdaq Composite Index shed 73.74 points, or 3.26%, to close at 2,187.53. And the broader Standard & Poor’s 500 Index skidded 58.74 points, or 4.69%, to close at 1,192.96.

All sectors were down, with energy sector (down 6.84%), financial services (down 6.81%) and the basic materials sector (down 6.60%) enduring the largest declines.

Many experts now fear that the U.S. financial sector faces a “crisis of confidence,” a potentially devastating psychological impasse from which there’s no easy escape. The stunning-and-sweeping moves, which are permanently reshaping the U.S. financial sector, are the latest chapter in a financial crisis that has resulted in hundreds of billions of dollars in losses – ostensibly due to bad real-estate loans, The New York Times reported.

In a move that mirrored the step taken by hedge fund Long-Term Capital Management 10 years ago this week, 10 major banks will create an emergency fund of $70 billion to $100 billion that financial institutions can use to protect themselves from the fallout of Lehman’s collapse.

As the news of Lehman’s bankruptcy filing roiled the financial markets, the U.S. Federal Reserve announced emergency measures designed to smooth volatility. Once such move includes having the Fed increase its loan program – buy widening the types of collateral available for loans.

“The steps we are announcing today, along with significant commitments from the private sector, are intended to mitigate the potential risks and disruptions to markets,” Fed Chairman Ben S. Bernanke said yesterday.

Speaking just ahead of the regularly scheduled meeting of the policymaking Federal Open Market Committee (FOMC) that is set for today (Tuesday), Bernanke outlined a plan designed to pump liquidity into the capital markets after U.S. Interbank lending rates zoomed to 6%, three times the Fed’s 2.0% target. It was the widest margin over the Fed’s target in more than a decade, and stems from the fact that – as the markets grow even more risk-averse – banks are holding onto capital and demanding a premium for lending.

After the central bank pumped $70 billion in temporary cash reserves into the capital markets system, the rate lowered to 4%, according to Bloomberg data.

It had been widely anticipated that the FOMC would vote to hold its key interest rate steady at 2.0% when it meets today. But with the collapse of Lehman Brothers, Fed Funds futures traded on the Chicago Board of Trade are pricing in an almost 72% chance of a quarter-point reduction in the benchmark Federal Funds rate.

Prior to Lehman’s Monday morning bankruptcy filing, futures indicated only a 12% chance of such a cut.

Paul Mortimer Lee, economist at France’s BNP Paribas SA (OTC ADR:BNPQY), said the Fed would either cut rates by a half-percentage point or signal that a rate cut could come soon, MarketWatch reported.

“So, in short, they either talk dovish or act and talk dovish,” Lee wrote in a research memo to clients.

The Fed has also expanded the types of securities that can be pledged for collateral at the Primary Dealer Credit Facility. Previously, the PDCF had been limited to investment-grade securities. Now collateral “has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks,” the Fed statement said.

On Sept. 12, the effective Fed funds rate was 2.1%, only 10 basis points above the Federal Reserve’s target rate. If the Fed’s emergency measures do not have their intended affect, it could force the FOMC’s hand into making a rate cut.

“If the Fed Funds rate closes high today, I would be really worried as it would mean that there really is no money out there to be lent,” Stan Jonas, who trades interest-rate derivatives at Axiom Management Partners LLC in New York, told Bloomberg.

It remains to be seen whether the sale of Merrill Lynch, the “controlled demise” of Lehman and the intervention into the fate of other key U.S. financial giants will be enough to keep the broader U.S. economy from getting swept into a stagflationary recession.

Source: Buyout of Merrill and Bankruptcy of Lehman Heightens Worry of U.S. Credit Crisis Pain Still to Come