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Fed teams with central banks on credit crisis

The Federal Reserve announced Wednesday it was coordinating with other central banks to deal with the global credit crunch. Stocks rallied briefly after the surprise announcement.
/ Source: The Associated Press

The Federal Reserve on Wednesday announced a novel approach to injecting money into the banking system as it struggles to combat a severe credit crunch that threatens to drag the country into a recession.

The announcement helped dispel the sour mood on Wall Street, where investors had pushed the Dow Jones industrial average down by 294 points on Tuesday out of disappointment with what was seen as a timid interest rate cut. After Wednesday’s announcement, stocks recouped a part of the previous day’s losses, but had lately given up their gains.

The Fed said it would conduct two auctions next week where banks can bid for up to $40 billion in loans, money that they will have to bolster their own reserves. It marked the Fed’s biggest concentrated effort to inject liquidity into the banking system since the Sept. 11, 2001, terrorist attacks.

The hope is that the extra funds will spur increased lending on the part of the banks and combat a serious credit crunch that has made loans harder to obtain for many businesses and consumers.

In afternoon trading, the Dow Jones industrial average was up more than 80 points.

The Fed linked the new auction process to an announcement that it was extending a line of credit in dollars to the European Central Bank and the national bank of Switzerland so that those institutions could better deal with credit problems in Europe. The Fed said it was also coordinating with the central banks of England and Canada.

The efforts seek to restore market confidence that Federal Reserve Chairman Ben Bernanke and his colleagues at the Fed and the monetary authorities in other countries were doing enough to deal with the spreading global credit crisis.

Private analysts expressed approval of the Fed’s efforts, saying they marked a much better response following what they viewed as a botched rate cut announcement on Tuesday. The rate cut was widely seen as not bold enough in light of the serious problems facing the economy.

“They are trying to help hard-pressed banks raise much-needed cash. The banking system is under severe pressure because the banks don’t want to lend to each other,” said Mark Zandi, chief economist at Moody’s

The Fed’s new program will begin with two auctions next week and another two in January. The first auction for up to $20 billion will occur on Dec. 17, followed by a Dec. 20 auction for another $20 billion.

The Fed is trying the auction program as an experiment to provide another avenue for providing loans to banks because banks have shied away from borrowing from the Fed’s discount window because of the stigma that can be linked to banks who make frequent use of it.

“This is a creative way to try to get more cash into the system without marking anyone as being in trouble,” Zandi said.

In a statement timed before the start of trading on Wall Street, the Fed said it would hold two more auctions on Jan. 14 and Jan.

28. The size of the January auctions will be determined later.

“This is not about particular financial institutions with particular problems. It is about market functioning,” said a senior Federal Reserve official who briefed reporters on condition of anonymity because of the sensitive nature of the actions.

This Fed official, who spoke to reporters on a conference call, said that the adverse reaction of Wall Street on Tuesday had nothing to do with the timing of the announcement. This official said discussions with other central banks about an enhanced action plan had been ongoing for some time.

Wall Street investors and private economists generally applauded the Fed’s latest effort to combat the country’s worst credit crisis in nearly a decade. But private economists said it still was unclear just how successful the auctions would be in overcoming banks’ concerns about getting direct loans from the Fed.

“Clearly, the Fed is feeling its way in the dark here. Current conditions are unprecedented in modern times,” said Ian Shepherdson, chief U.S. economist at High Frequency Economics.

The Fed said that commercial banks would be able to bid at auction for funds that would be drawn from the newly created Temporary Auction Facility.

The Fed said all banks judged to be in generally sound financial condition by their Fed regional bank would be eligible to participate in the auctions for funds.

The Fed said that the new auction process should “help promote the efficient dissemination of liquidity” when other lines of credit were “under stress.”

The experience gained from the four scheduled auctions would be “helpful in assessing the potential usefulness” of this new process to provide funds to U.S. banks, the central bank said. Fed officials indicated more auctions would be scheduled if the first four were successful.

The Fed statement said the temporary swap arrangements being set up would provide up to $20 billion in reserves for the European Central Bank and up to $4 billion for the Swiss National Bank. The reserves would be available for up to six months.