* Treasury set to halt federal pension fund investments
* May also tap exchange rate fund to avoid default
* Treasury says will be able to pay bills into September
WASHINGTON, May 17 (Reuters) - The Obama administration on Friday notified Congress it was prepared to take a series of steps to free up about $260 billion so it can keep paying the nation's bills once a temporary suspension in the government's debt ceiling lapses this weekend.
To preserve its borrowing capacity, the U.S. Treasury Department said it would employ the same measures it has used previously when Congress had failed to raise the limit, including halting investments in two different federal employee pension funds.
In a letter to congressional leaders, Treasury Secretary Jack Lew said the extraordinary actions should allow the government to meet all its obligations at least through the Sept. 2 Labor Day holiday.
If the debt ceiling is not raised by then, he said the nation would run the risk of an economically damaging default.
"Congress should act sooner rather than later to protect America's good credit and avoid the potentially catastrophic consequences of failing to act until it is too late," Lew said.
Republicans in Congress want to use the need to raise the borrowing cap as leverage to seek fresh budget cuts and tax code changes. President Barack Obama has said any deal to cut the budget deficit would need to include additional revenues, an idea that is anathema to many conservatives.
In 2011, the Obama administration and Congress battled for months before raising the debt ceiling to $16.4 trillion. The fight hurt consumer confidence, shook financial markets and cost the United States its top-tier credit rating.
Earlier this year, Congress decided to side step a messy fight and put in place legislation that suspended the limit.
When that suspension expires on Sunday, the new ceiling will be set at the existing level of the nation's debt, which is around $16.7 trillion.
It will also set the clock ticking toward another potential bitter showdown over the budget this summer.
"In order to avoid a repeat of the damaging brinkmanship that occurred in 2011, Congress should remove the threat of default by taking this action as soon as possible," Lew said.
The Treasury took the first step to free up borrowing authority this week with a decision to suspend sales of special Treasury securities that state and local governments use to temporarily invest proceeds from sales of municipal bonds.
In addition to that step, and the possibility of putting a temporary halt to pension fund investments, the Treasury said it could dip into a seldom-used fund it taps to intervene in currency markets.
It ruled out some other measures, including halting sales of savings bonds.
Normally, these measures would buy the Treasury about two months before it would run out of cash. But unexpectedly strong tax receipts and sizable bailout payments from mortgage finance firms Fannie Mae and Freddie Mac are giving the Treasury more time.
While Lew said the measures would buy time until at least early September, many private forecasters believe the drop-dead date will not be reached until October and the non-partisan Congressional Budget Office estimates it could be as late as November.