Fed to start buying commercial paper

By Chris Giles in London,Tony Barber in Brussels, Michael Mackenzie in New York and James Politi in Washington

Published: October 7 2008 14:33 | Last updated: October 7 2008 18:47

Ben Bernanke on Tuesday opened the door to further US interest rate cuts on a day that saw the Federal Reserve moving to bypass banks and lend directly to American companies in an unprecedented attempt to unfreeze the money markets.

The Fed’s move into the market for commercial paper – short term debt issued by companies and others to fund day-to-day operations – represents a dramatic expansion of its role of lender of last resort, but its extraordinary action failed to calm nerves in feverish markets.

Although global stock markets initially regained some poise after Monday’s severe falls, the Fed’s action had little initial effect on money markets and the S&P 500 index was down a further 2.47 per cent in afternoon trading in New York. Overnight bank-borrowing costs jumped and bank shares in Europe slumped for a second day, partly on talk that European governments would soon take individual action to recapitalise banks at the expense of shareholders.

In a speech in Washington DC, Mr Bernanke, Fed chairman also appeared to signal further rate cuts to tackle the financial crisis, saying it would “need to consider whether the current stance of policy remains appropriate” although he stopped short of explicitly signalling that the main US interest rate would be cut from 2 per cent.

Earlier, the Fed said it would set up a new Commercial Paper Funding Facility to buy three-month debt from banks and non-financial companies.

“This facility should encourage investors to once again engage in term lending in the commercial paper market...[and] lower commercial paper rates from their current elevated levels and foster issuance of longer-term commercial paper,” the Fed said in a statement.

After the news, overnight rates on commercial paper eased, but interest rates for longer-term lending remained elevated. Analysts welcomed the Fed’s move to kickstart lending in the $1,600bn commercial paper market which has shrunk by an eighth in the past three weeks.

”This action will help mitigate the risks of an even sharper deterioration in the economy,” said TJ Marta, strategist at RBC Capital Markets.

One of the more positive signs after the announcement was a sign that some of the flight to the safety of government bonds was diminishing. The yield on the two-year US Treasury note rose 9bp to 1.49 per cent, but this level still well below the current Fed funds rate of 2 per cent.

In Europe the sense of crisis deepened as EU finance ministers, meeting in Luxembourg, agreed that governments should be free to take part in bank rescues, so long as support is temporary, shareholders’ rights are diluted, and the effects of rescues do not spill over from one country to another.

In Britain, the prime minister, chancellor, Bank of England governor and chairman of the Financial Services Authority met last night to finalise plans for a publicly backed recapitalisation plan for Britain’s banks to be announced before the markets opened on Wednesday.

Britain’s bank shares suffered a second terrible day with Royal Bank of Scotland and HBOS equities plunging 39 and 42 per cent respectively.

Iceland‘s national crisis intensified as the government nationalised Landsbanki, its second largest bank, guaranteeing domestic deposits but international creditors, sought a €4bn loan from Russia and tried to peg its currency. An team from the International Monetary Fund is already in the Reykjavik but the Fund has not yet been approached by the government.