Fed Boosts Cash Auctions to $900 Billion, May Do More (Update2)

Oct. 6 (Bloomberg) — The Federal Reserve will double its auctions of cash to banks to as much as $900 billion and is considering further steps to unfreeze short-term lending markets as the credit crunch deepens.

“The Federal Reserve stands ready to take additional measures as necessary to foster liquid money-market conditions,” the central bank said in a statement released in Washington today. Fed and Treasury officials are “consulting with market participants on ways to provide additional support for term unsecured funding markets,” the statement said.

Today’s steps follow a hoarding of cash by banks that sent the premium on the three-month London interbank offered rate over the Fed’s benchmark interest rate to a record. Industrial companies are also finding it harder to raise cash after the market for commercial paper shrank to a three-year low as investors flee even borrowers with few links to mortgages.

“It is pretty much all out war,” said Christopher Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd., New York. “They are pulling out all the stops to try and get borrowers and lenders to meet and do transactions once again.”

Implementing part of last week’s emergency legislation to shore up the financial industry, the Fed said today it will begin paying interest on the cash reserves banks hold at the central bank. The step should give Fed officials greater power to inject cash into banks without interfering with their benchmark interest rate, which stands at 2 percent.

Bernanke Speech

Fed Chairman Ben S. Bernanke‘s speech on the economic outlook tomorrow in Washington should give an indication of whether U.S. central bankers are prepared to cut the main rate before the next meeting Oct. 28-29, Rupkey said.

As part of today’s steps, the Fed will increase its auctions under the 28-day and 84-day Term Auction Facility operations to $150 billion each. The two forward TAF auctions in November will be increased to $150 billion each, the Fed said.

Money market rates are climbing worldwide on concern the deepening credit crisis will cause more financial firms to collapse. Three-month Libor climbed to 4.29 percent today, the biggest premium over the Fed’s benchmark since the central bank began using a target for the overnight federal funds rate between banks as its main tool around 1990.

In Europe, governments rushed to shore up their faltering banks as the credit crunch worsened there. BNP Paribas SA agreed to buy Fortis’s units in Belgium and Luxembourg for 14.5 billion euros ($19.8 billion) after a government rescue failed, while the German state and financial institutions put together a 50 billion euro rescue package for Hypo Real Estate Holding AG.

International Effort

President George W. Bush‘s working group on financial markets, a body that includes the Fed, Treasury, Securities and Exchange Commission and Commodity Futures Trading Commission, said today it’s working with “market participants and regulators globally to address the current challenges to restore confidence and stability to financial markets.”

The working group statement comes four days before a gathering of central bankers and finance ministers from the Group of Seven major nations in Washington.

The Fed gained the authority to pay interest on commercial bank reserves under the $700 billion financial-rescue legislation approved last week. The Treasury will purchase distressed assets from financial companies under the plan.

To finance the Treasury’s new plans, officials are considering changes to federal government debt sales, including a reintroduction of three-year notes. Any changes will be released at the Treasury’s Nov. 5 quarterly announcement on sales of long-term debt.

Treasury Issuance

The Treasury also said that some of its cash-management bills may be “longer-dated.” The expansion in issuance is needed to “allow Treasury to adequately respond to the near- term increase in borrowing requirements,” the department said. Treasury officials last month also started a special program of bill auctions to help the Fed expand its balance sheet.

Fed payments on required reserves will be made at the average targeted federal funds rate established by the Federal Open Market Committee over each so-called reserve maintenance period less 10 basis points.

In addition to the cash banks must hold at the Fed, lenders also sometimes place excess reserves. The central bank said today it will pay interest on those funds at the lowest targeted federal funds rate for each period less 75 basis points. That will put a floor under the actual fed funds rate each day and let the Fed `expand its balance sheet as necessary to provide the liquidity necessary to support financial stability.”

Managing Rates

The Fed created the TAF auctions of cash to commercial banks in December, and has continually expanded the program since then. To prevent a surfeit of funds in the system from pushing the actual overnight interbank lending rate below the Fed’s target, the central bank withdraws liquidity through repurchase operations.

As the Fed pumped cash through the TAF and other programs at record levels last month, the New York Fed had difficulty controlling the daily federal funds rate. While the target is 2 percent, the effective rate was below that level every day from Sept. 19 to Sept. 29.

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