Fed keeps tools handy and calms Wall Street

By Emily Kaiser and Mike Peacock

WASHINGTON/LONDON (Reuters) - Federal Reserve Chairman Ben Bernanke signaled a willingness to consider an early cut in the benchmark interest rate to quell market unrest, a key U.S. lawmaker said on Tuesday after meeting with the Fed chief.

However, the U.S. Treasury secretary cautioned it would take time for the credit crisis to play out, and skittish U.S. stock markets struggled to sustain modest afternoon gains.

Stocks initially rose after Sen. Chris Dodd, who chairs the Senate Banking Committee, said Bernanke was "absolutely" willing to use all available tools to ease a credit squeeze that has limited companies' ability to raise funding.

Finance chiefs from Japan and Germany also tried to reassure investors that they were watching the situation closely.

The Dow Jones industrial average ended the session 0.23 percent lower on persistent worries that troubles in the mortgage market were spilling into other forms of credit. The broader S&P 500 index closed up a slim 0.11 percent.

Capital markets remained tight and many investors were calling on the Fed for a cut in its benchmark interest rate, policymakers' main monetary tool.

Richmond Federal Reserve Bank President Jeffrey Lacker poured some cold water on hopes for an imminent interest rate cut, saying market turmoil only warrants a change in rates if it affects the outlook for inflation or growth.

Nervous investors piled into short-dated Treasury debt, a traditional sanctuary from volatile markets, driving prices higher for a ninth straight session.

"Portfolios are in hyper-risk-averse mode," said Joseph Di Censo, fixed-income strategist at Lehman Brothers in New York.

The Fed has already stepped in with billions of dollars in temporary reserves in recent days, plus Friday's surprise half-point cut in the discount rate on direct loans to banks,

Treasury Secretary Henry Paulson, who attended the meeting with Dodd and Bernanke, warned investors that financial markets would improve only after a necessary period of adjustment.

"We've had some bad lending practices," he told CNBC television. "There's not going to be a quick solution to some of the issues in the credit markets, but ... we will work through these issues because we have an economy that's strong."

Capital One Financial Corp, best known for its U.S. credit card business, on Monday announced it will cut 1,900 jobs and shut down a wholesale mortgage unit it acquired less than a year ago.

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In Japan, Finance Minister Koji Omi earlier told a news conference there were no plans for an emergency meeting of the Group of Seven industrialized nations following sharp gyrations in global markets.