Fed mulls liquidity tools but ammunition limited

NEW YORK (Reuters) - The U.S. Federal Reserve is considering further steps to deal with a renewed surge in money market interest rates, but the central bank may be limited in what it can do by the market's major problem -- fear.

Money market rates around the world have surged in recent weeks as year-end funding needs have been exacerbated by growing worries about further bank losses as U.S. mortgages default rates climb.

Fed Vice Chairman Donald Kohn acknowledged on Wednesday that the short-term funding market remained under stress, and said central banks should look at what they can do to help.

"Central banks, including the Federal Reserve, need to give some thought to how all their liquidity facilities can remain effective when financial markets are under stress," he said.

But Kohn admitted central banks can only address one of the worries confronting the market, the need to get hands on enough cash when cash is scarce.

"Banks may be worried about access to liquidity in turbulent times," Kohn said. "Such a concern would lead to increased demands and reduced supplies of term funding, which would put upward pressure on rates."

"This ... concern is one that central banks should be able to address," he said.

But Kohn said the Fed was not equipped to do what financial firms themselves can not do: determine where the bodies are buried and how much cash might be need to cover losses.

NO RADICAL MOVES

For now, analysts say the Fed is likely to expand on the range of tools it already has tapped to provide liquidity, such as offering more longer-term repurchase agreements, easing conditions on collateral, and further cutting the discount rate governing direct Fed loans to banks.

"The Fed will likely do something on the fringes" of current options rather than something radical, said Michael Feroli, economist at JPMorgan in New York.

On Monday, the New York Fed made an unusual announcement, saying it would provide more than the usual year-end liquidity, starting with a funds injection it made on Wednesday, and that it was lifting the limits on how much can be lent to any one bank.

Some Fed watchers have wondered whether the Fed might go further and reduce the "penalty" for borrowing at the central bank's discount window.

In recent years, the Fed had held the interest rate charged on discount lending a full percentage point above its target rate for overnight inter-bank loans. However, when credit market problems first became apparent in August, the Fed had slashed that penalty to a half a percentage point.

Kohn said on Wednesday that lowering the penalty rate further was not "off the table," although he expressed reservations about eliminating it altogether.

The discount rate now stands at 5.0 percent, while the overnight federal funds rate is at 4.5 percent.

The Fed is widely expected to lower the federal funds rate target by a quarter-point at its next meeting on December 11 and Richard Iley, a senior economist at BNP Paribas in New York, said Kohn's comments suggest "that a larger than 50 basis point reduction in the discount rate is a real possibility."

But discount window borrowing by bank has been hampered by the stigma of being perceived as being a bank in distress if borrowing directly from the Fed.

Some analysts have pointed to the possibility of more unorthodox measures in line with steps the Fed took in anticipation of funding needs ahead of the millennium date change in late 1999 and after the September 11, 2001, attacks.

Among other steps, the Fed in late 1999 sold options on overnight repurchase agreements to assure financial firms they would have access to cash at a time many firms were having trouble determining what their cash needs might be.

After the September 11 attacks, the Fed entered into currency swap agreements with some other major central banks to provide dollar liquidity in markets outside of the United States.

So far, these options do not seem forthcoming.

Ultimately, further cuts in the federal funds rate might be the most powerful weapon the Fed has at its disposal. It would both ease bank borrowing costs and help put a floor under a deteriorating economy.

(Reporting by Tamawa Kadoya; editing by Clive McKeef)