FED FOCUS-Fed tries to ease credit, hold line on rates

By Ros Krasny

CHICAGO, Sept 18 (Reuters) - As the U.S. Federal Reserve and other central banks pump massive liquidity into a frozen global financial system, an emergency interest U.S. rate cut remains a last-ditch outcome.

With the focus on crisis management, and at a time a string of rescue moves has run down the Fed's reserves to critical levels, policy-makers are grasping for ways to expand their capacity to support money markets while keeping those efforts apart from interest-rate policy.

On Thursday, the world's top central banks turned the funding taps open wide. The Fed increased currency swap lines with other central banks by $180 billion to help them meet demand for U.S. dollars in their markets and ease extreme funding strains in the global banking system.

That came less than 48 hours after the Federal Reserve's decision to hold interest rates steady. The Fed announced its decision in a statement that stayed tough on inflation and offered only a nod to extreme credit market disruptions.

"The Fed (this week) was trying to separate liquidity additions from rate policy," said Alan Ruskin, chief international strategist at RBS Greenwich Capital in Greenwich, Connecticut.

But just hours after the Fed decided to hold rates steady, it agreed to rescue ailing insurance giant American International Group (AIG.N) with a loan of $85 billion, creating another seismic shift in the financial landscape.

The Fed's overnight announcement on Thursday that it was increasing swap lines with the European Central Bank and Swiss National Bank and setting up such lines with other central banks will probably not be its last emergency move.

"More actions could be forthcoming in the next few days and weeks, including the possibility of a rate cut ... and almost certainly more special bill auctions by the (U.S.) Treasury," said economists at Goldman Sachs. In a highly unusual move, the Treasury on Wednesday began to auction off U.S. government debt to shore up the Fed's now-tattered balance sheet.

Chicago Federal Reserve Bank President Charles Evans could lay out some options on Friday, when he speaks in Zurich on "Challenges that the Recent Financial Market Turmoil Place on our Macroeconomic Toolkit."

BALANCE SHEET GETS LEAN

The need for the special Treasury auctions has became urgent after the Fed ran down its balance sheet with a series of costly rescue moves, culminating in the AIG deal.

"The Fed is very close to using up its lending capacity." That's unprecedented," said Marvin Goodfriend, a professor at Carnegie Mellon University's Tepper School of Business and former monetary policy adviser at the Richmond Federal Reserve Bank.

The special auctions were established at the request of the Fed. Already, the Treasury has sold off $100 billion in bills under the program and has announced sales of $100 billion more.

"Short of running up against a debt ceiling ... we know of no limit to the amount that Treasury could raise through this process," the Goldman economists said. The Treasury could issue more than $1 trillion in additional debt before it hits the congressionally set debt limit.

Fed holdings of Treasury securities were $478 billion as of Sept. 10, down from $741 billion at the start of the year after a series of emergency operations to keep credit flowing.

Analysts estimate that after extending the credit lifeline to AIG, the Fed has less than $200 billion in unpledged assets remaining, undercutting its ability to deal with what seems like an unending liquidity crisis.

"There are very big questions involved about the government issuing debt to fund the Fed's lending program. But for all practical purposes, the government will do what it needs to do," said Goodfriend.

QUANTITATIVE EASING ON TAP?

The Fed asked Congress in the spring for a go-ahead to start paying interest this year on the reserves that commercial banks hold at the central bank, which would open the door to a new way to ease credit strains.

If given the authority, the Fed could ramp up its operations to provide liquidity to markets and expand its balance sheet without lowering benchmark borrowing costs -- a process known as quantitative easing.

Fed officials believe Congress is inclined to agree to its request. On Wednesday, a key lawmaker said Congress wants to approve the plan, but is looking for ways to cover the estimated $300 million cost.

The authority could be tucked into pending legislation to fund the government past the start of the next fiscal year on Oct. 1.

The New York Federal Reserve Bank, which oversees the central bank's open market operations, last month said the authority would give the Fed greater flexibility to attack tight liquidity conditions.

Goodfriend, who promoted the idea in a 2002 paper, said the ability to leave interest-rate policy untouched while expanding its balance sheet "would be a powerful tool for the Fed, extremely useful."

If the program had been in place now, the Fed might have been able to get by without the new Treasury auctions, he said.

The jury remains out, however, on quantitative easing. The Bank of Japan's experiment in quantitative easing from 2001 to 2006 to stimulate its stagnant economy has drawn mixed reviews on whether it was a success.

"In strengthening the performance of the weakest Japanese banks, quantitative easing may have had the undesired impact of delaying structural reform," the San Francisco Fed's senior vice president Mark Spiegel argued in a 2006 article.