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With Credit Still Tight, Fed Mulls Ways to Boost Liquidity

As the Federal Reserve hones in on the end of its interest-rate cutting campaign, officials remain troubled by lingering stress in credit markets and continue to mull steps to ease the strain.

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The Fed has been waging a two-front battle against a credit crunch that has paralyzed financial markets and put a strait-jacket around the economy.

It has cut rates sharply and has offered a menu of options for commercial and investment banks to obtain the credit they can't find in the open market.

Now, officials suggest that after a rate-cutting spree that has taken benchmark borrowing costs to 2.25 percent from 5.25 percent since mid-September, they may soon step to the sidelines to see if the rate reductions and a government stimulus package that will put billions of dollars into consumers' pockets have their intended curative effect.

When it wraps up a two-day meeting Wednesday, the Fed is expected to lower rates by a slim quarter-percentage point, a move financial markets believe will be the last in the cycle.

However, Fed officials see persistently shaky conditions in short-term funding markets and signs financial institutions are still in a defensive crouch, and continue to explore whether further actions to ease liquidity strains would be helpful.

Any further steps may draw on the experience of other central banks, which have offered financial institutions funding for longer durations.

In addition, the Fed could decide to expand currency swap lines with other central banks.

A key indicator of short-term lending, the gap between the three-month London Interbank Offered Rate, or Libor, a gauge of what banks charge each other for loans, and overnight indexed swaps, a measure of anticipated benchmark interest rates, remains elevated and has raised concerns at the Fed.

"Gyrations in the spread between Libor and the overnight index swap rate ... demonstrate that we continue to have episodes where the spreads become large by historical standards," Boston Federal Reserve Bank President Eric Rosengren said last week.

Tight short-term credit conditions have diluted the effects of the Fed's reductions in borrowing cost, frustrating policy-makers who want their rate cuts to lift the economy.

"The rise in Libor does short-circuit part of the easing in monetary policy on financial conditions, which in turn means economic activity will be more restrained than it otherwise would have been," Goldman Sachs economist Ed McKelvey wrote in a note to clients.

Trying to Ease the Strain

The Fed could expand the size of its term auction or term securities lending facilities or extend beyond a month the duration of the cash loans or securities swaps.

Actions taken by other central banks to ease credit market strains are being watched closely at the Fed to see how effective they may be, and those experiences will likely help shape any future moves the U.S. central bank may take.

The Bank of England has offered banks funding for up to a year, and the European Central Bank offers credit on 3-month and 6-month terms.

The Fed could also bolster foreign exchange swap lines that allow central banks in Europe to pump dollars into their markets.

It has established swap lines of up to $30 billion with the ECB and $6 billion with the Swiss National Bank, both of which expire on September 30.

While Fed officials remain open to further moves they feel the steps they have already taken have helped unclog credit markets and some are skeptical that lending at longer maturities would necessarily prove effective.

Banks in Europe continue to pay high premiums to obtain three-month and six-month credit from the ECB, exhibiting a degree of caution that has surprised ECB officials.

"Banks ... continue to bid for liquidity in the weekly, three-month and six-month ECB tenders at much higher interest rates, apparently pricing in a risk that does not exist at all," ECB Executive Board member Lorenzo Bini Smaghi said on April 4.

At the same time, central banks are actively discussing recommendations issued at a meeting of Group of Seven financial officials on April 11 that they establish links among themselves to erect more of a global bulwark against future liquidity crises.

Those recommendations from the Financial Stability Forum include the establishment of standing -- rather than temporary -- currency swap lines.

Central banks should also accept high-quality collateral denominated in a range of currencies, the FSF urged.

The recommendations have support at the Fed, where the idea of making it easier for banks to mobilize liquidity from around the world is seen as a way to help ensure a smooth flow of funds.

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