New Fed plan calms markets, but no silver bullet

WASHINGTON (Reuters) - A bold $200 billion lending plan unveiled by the Federal Reserve on Tuesday won applause for creative thinking and calmed stressed markets, but failed to convince skeptics that it was a silver bullet.

"It is a constructive step, but it is not a full solution," said economist Brian Sack at Macroeconomic Advisers.

"It does not reduce the amount of mortgage-related risk that the private sector has to bear. It does not solve the capital pressure on banks," said Sack, a former senior Fed economist.

The Fed has already cut interest rates by 2.25 percentage points since mid-September to shield the economy from a collapse in the U.S. subprime market that has chilled growth and sparked a global credit crunch.

In addition, it had previously taken a number of other steps to help provide liquidity to markets.

Its latest move, however, goes beyond those steps by allowing triple-A rated privately issued mortgage backed securities to be swapped for U.S. Treasuries. In combination with actions announced on Friday, the Fed has vowed to make an additional $400 billion available to markets.

"The Fed by accepting MBS as collateral is now attempting to inject liquidity directly to the area that is the source of the credit crunch," said Doug Roberts, chief investment strategist for Channel Capital Research.

The Fed's announcement was coordinated with the European Central Bank, Bank of England and other major central banks. The united front in itself could help restore confidence.

"The principle message is key central banks are well aware of what is going on and are willing to take action, and in the case of the Fed willing to take innovative action," IMF First Deputy Managing Director John Lipsky told Reuters.

News that policy-makers were willing to take more muscular action led to a 416-point rally for the Dow Jones industrial average .DJI and narrowed credit market spreads.

"The Fed's actions reflect an attempt to use their balance sheet to try to extinguish the fires that seem to keep blazing across the financial markets," Morgan Stanley economist David Greenlaw wrote in a note to clients. "Today's announcement clearly had a significant impact."

SPREADS NARROW

Spreads on Fannie Mae FMM.N and Freddie Mac (FRE.N) mortgage-backed securities tightened sharply along with corporate bond spreads, and the main U.S. investment-grade credit derivative index rose 9 percent.

Senior Fed staffers said they hoped the measures would help reduce risk premiums in the MBS market by assuring dealers they can swap these securities for Treasuries. This, in turn, should help stabilize the wider market, they said.

Part of their confidence is based on the success that earlier liquidity initiatives have had in calming markets.

The initial relief those effort provided, however, was subsequently overwhelmed as a spate of fresh problems emerged in parts of the market that had previously been stable, like debt for municipal borrowers.

"For now, the current Fed move will purchase a fortnight of peace," said Joseph Brusuelas, chief U.S. economist at IDEA Global, who said more aggressive efforts would likely be needed to shore up the U.S. financial system.

However, the Fed noted that it could very quickly increase the scale of the new lending program, which leaves the door open to the possibility they will keep pumping billions of dollars into the system until calm is restored.

"If this action is insufficient, there will be willingness to take further action," Lipsky said.

The new securities lending facility is easier to increase in size than other steps the Fed has taken simply because it swaps one type of security for another, and thus does not impact the central bank's balance sheet.

Senior Fed staffers told reporters during a telephone conference call that it still had a lot of balance sheet capacity left. Morgan Stanley put this at another $430 billion-worth, after accounting for recent liquidity measures.

"It's important to recognize that if the situation were to become sufficiently dire, the Fed has unlimited power to monetize the economy's debt," Morgan Stanley's Greenlaw noted.

(Reporting by Alister Bull; Editing by Leslie Adler)