Credit Crunch: Fed lays on extra liquidity support

The Federal Reserve ramped up its liquidity support operations again on Wednesday in an effort to reduce money market strains and pre-empt the possibility of funding crises at the year-end or at other stress points. The US central bank said it would offer three-month cash loans to banks and create a new options auction facility. It also said it would give investment banks and other primary dealers extended access to emergency cash and loans of Treasury securities until January 30 reports the Financial Times.

The Fed said it was extending its support to primary dealers “in light of continued fragile circumstances in financial markets”.

The options facility is similar to the strategy used by the Fed in 1999 to deal with the risk of a millennium Y2K liquidity crisis. The Fed will auction $50bn of options giving dealers the right but not the obligation to swap illiquid securities for Treasuries over periods of likely funding stress, such as the year-end.

The European Central Bank and the Swiss National Bank will also offer three-month dollar loans through an offshore facility set up with the Fed. The Fed will increase the amount of dollars it provides to the ECB in exchange for euros by $5bn to $50bn.

Goldman Sachs said the moves “should help to . . . alleviate market stresses, but are incremental rather than transformational”.

Its initiatives follow the recent turmoil in financial sector stocks, which has created a risk that the credit squeeze in the real economy could intensify in the coming months.

The US central bank does not believe it can solve what are in many cases capital problems by providing extra liquidity. But it does believe it can support the adjustment process by reducing the risk of a liquidity run on any individual institution or any forced firesales of illiquid assets.

The Fed’s acknowledgement of the continuing stress in financial markets makes it improbable that it will raise interest rates soon. However, in the longer term, Fed policymakers believe that liquidity tools and rates could in principle diverge.

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