The global credit crisis and the US economic upheavals that are driving it appear to have entered a new, more dangerous phase.

Last week's relentless spate of tribulations for the world's financial markets, culminating in an emergency bailout of Bear Stearns, the stricken investment bank, marked a scary escalation of events.

Little wonder, then, that the markets are pinning their hopes on tomorrow's meeting of the Federal Reserve for some respite from the deluge of grim news, and a further restorative dose of interest rate cuts.

Wall Street is hoping that the Fed's latest tonic will come in the form of another aggressive three-quarter-point reduction in official rates, and perhaps even a cut of a full percentage point. The Fed will very probably fulfil these expectations.

Yet any market euphoria that greets this near-inevitable decision should be regarded as what Alan Greenspan, the Fed's former Chairman, called “irrational exuberance”.

Although the lingering faith of investors in the power of rate cuts as an invigorating cure-all is touching, the bleak reality is that, for all the unprecedented aggression of the Fed's recent action, its medicine is more mere palliative than panacea.

The efficacy of monetary policy to quell the present turmoil, and to break the vicious downward spiral into which the US economy is locked, is more and more in question.

Across the United States, house prices continue to slump, eroding Americans' wealth and confidence as growing job losses combine to sap consumer demand, reinforcing the downturn.

Although the Fed's cuts in official rates, likely by tomorrow to total at least 2 percentage points since January alone, can help to limit the damage, and limit the depth of the recession that America has probably already entered, this is the most that can be hoped.

The feebleness of monetary policy in this fight is clear from the way in which, even as official rates have been cut, actual market interest rates paid by households and businesses have continued to climb because of the still-tightening credit squeeze.

At work is the so-called “financial accelerator” that now threatens to propel the US economy towards the abyss at a frightening speed.

As house prices tumble, and banks' losses on loans and toxic mortgage-backed securities multiply, the banks act to protect themselves and bolster their fragile balance sheets by ring-fencing capital and scaling back new lending. This drives up market rates still higher, adding to real and potential losses, reinforcing the credit squeeze and ratcheting up the pain.

The intensity and scale of this process was laid bare last week by the Bear Stearns debacle. Yet it is clear that the Fed's power to slam on the brakes and counteract the power of this financial accelerator through interest rates is severely constrained.

Worse still, the widespread belief that the Fed's rate cuts are an unalloyed good, and carry no risks or potentially negative repercussions, is also badly misplaced. Instead, the Fed's measures have a high-risk element that flows from their closely interwined impact on inflation, on markets' expectations of future inflation and on the dollar.

Ultimately, it seems probable that US inflationary pressures will be quashed by the sharp drop in demand that is taking hold. For the moment, however, headline inflation remains high, running at an annual 4 per cent rate that is eating away at Americans' spending power and adding to the consumer squeeze.

It is increasingly apparent that, whatever the eventual outcome, the markets have become fretful over the inflation risks being courted by the Fed and its Chairman, Ben Bernanke.

Those anxieties were made clear last week by the latest bizarre development in this crisis, as the yield on US index-linked Treasury bonds, or Tips, turned negative for the first time. In other words, in order to insulate some of their capital from the perceived inflation threat through Tips, investors are now prepared to lock in a guarantee that real returns will be negative.

That points to very real inflation fears, and to the first danger posed by the Fed's strategy. Should deep cuts in official rates inflame markets' inflation concerns, and lead toa sell-off in the bond markets, then the bond yields that determine actual interest rates for households and businesses will be pushed higher, making the Fed's moves counterproductive.

However, the greater peril stems from the rapid plunge in the dollar that has gathered pace in recent weeks and left the greenback languishing at record lows.

The Fed's steep rate cuts, and rising market fears over inflation, are piling pressure on the dollar. And as the dollar slides, it drives up US import bills, reinforcing inflationary pressures and further eroding confidence in the currency.

The consequence is that having fallen by 10 per cent against the euro over the past year, the greenback has shed a further 6.5 per cent in just the past month. Its overall value, gauged by its broad, trade-weighted index, is also at record lows.

The very real danger is that, while the boost to exports from the dollar's slide provides a helpful prop to US growth, its decline now becomes a rout, as investors' fears over its future value and of higher inflation trigger a loss of faith is American assets.

The materialisation of a long-dreaded dollar collapse would be catastrophic. It would undoubtedly trigger a crash in the equity and bond markets. A huge sell-off of US Treasury bonds by foreign investors would undercut the Fed's policy, driving long-term market interest rates through the ceiling. A severe world recession would become unavoidable.

This is a risk that the Fed, the United States, and the world cannot afford to run. The obvious implication is that the time has arrived for Washington to abandon its meaningless mantras claiming to support a “strong dollar”, while conniving to secure the opposite outcome. The dollar has fallen far enough, and the moment for the Fed and the US Treasury to co-ordinate intervention with Europe and Japan has arrived.

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