Markets got a heavy dose of their least favourite medicine on Monday: uncertainty, as the U.S. House of Representatives unexpectedly defeated the U.S. Treasury Department’s bailout plan. Rate cuts may now be in the offing.

The Treasury’s proposed US$700 billion plan to buyout illiquid mortgage-backed securities was narrowly voted down Monday afternoon, surprising the markets that expected the bipartisan agreement to be approved. It remains to be seen whether the plan can be revived, brought back in some modified form, or if a wholly new approach will emerge.

If not, Global Insight Inc. suggests that the baton for dealing with the fallout will pass quickly to central banks.

“We continue to move through uncharted waters as the House defeated the proposed TARP legislation this afternoon, sending markets into a major tailspin. After substantial modifications to the legislation over the weekend to appease both Democrats and Republicans, the defeat came as a surprise,” it notes.

“It is very disappointing that the House turned down the opportunity to pass major financial legislation which could have provided a bulwark of stability against continuing tough economic times,” says Tim Ryan, the Securities Industry and Financial Markets Association’s president and CEO. “Without this package, Treasury and the Fed will have to fall back on the one-off solutions they utilized over the last few months, which will be exhausting, more expensive and less effective.

The Financial Services Roundtable also expressed disappointment: “Congress needs to understand that this is not about Republican and Democrat, it’s about the economy. The U.S. needs legislation that will bring stability to the economy and restore confidence in the financial markets. We need legislation that will protect Main Street by bringing liquidity to the credit markets and by helping at-risk homeowners to stay in their homes and avoid foreclosures,” it said.

Global Insight says that it is unclear whether the legislation can be resuscitated. “In the meantime, the Federal Reserve and other central banks pumped massive amounts of liquidity into the credit markets today in an attempt to stabilize interbank lending conditions,” it notes.

“If the legislation is indeed moribund — as it seemed to be on Monday afternoon — then the baton will pass quickly to the Fed and other central banks to deal with the fallout, which would be further tightening of credit conditions and upward pressure on borrowing spreads,” Global Insight states.

It adds that a co-ordinated central bank rate reduction of 50 basis points, or more — by the Fed, the Bank of England, the Bank of Canada, and the Reserve Bank of Australia — is certainly not off the table given the scale of the crisis. “At a minimum we would be looking for the Federal Reserve to cut interest rates sooner rather than later.”