NEW YORK (Reuters) - Last week's spike in Libor offers a more accurate depiction of the borrowing costs between U.S. banks, and suggests that in order to loosen up credit markets the Federal Reserve will take measures in addition to a likely 25 basis point cut in interest rates this month, Citigroup analysts said on Monday.
Elevated bank costs have been one of the road blocks the Fed has tried to remove in a bid to encourage lending across the financial system and stimulate a flagging U.S. economy.
The London interbank offered rate on three-month U.S. dollar deposits jumped 20 basis points last week, as traders sharply pared bets the Fed will lower its federal funds target rate by 50 basis points.
Fed officials on Friday hinted they were reluctant to cut interest rates further as the economy also faces a threat from inflation.
Libor is a global rate benchmark for floating-rate consumer and corporate loans, It is also a basis for numerous exchange-traded and over-the-counter financial instruments.
If Libor continues to rise, it would essentially cancel out the expected quarter point cut by Fed at its two-day policy meeting next week, and cause policy-makers to take more aggressive steps to deal with the credit crisis, Citi analysts Scott Peng and Alexander Tyo wrote in a research note on Monday.
"This may induce the Fed to explore other avenues of liquidity injection such as quantitative easing," Peng and Tyo said in the research note.
They were referring to a monetary policy move implemented by the Bank of Japan in 2001 with the goal to revive that country's economy which was stagnant for a decade. Quantitative easing entails flooding the banking system with excess reserves, resulting in pushing the benchmark overnight bank lending to zero.
There has also been growing speculation that banks surveyed by the British Bankers Association daily for Libor have been understating their actual borrowing costs in a move to mask their cash needs.
"A more accurate portrayal of the interbank lending rate could make the Fed's job more difficult as expectations of a wider bank premium may nullify a significant portion of the next 25 basis point cut in the Fed funds rate," the Citi analysts wrote.
In an April 10 research report, the two Citi analysts estimated three-month Libor fixing understated the true interbank loan costs in a range of 20 basis points to 30 basis points.
On Monday, three-month dollar Libor was set at 2.92000 percent, up 1.750 basis points from Friday.
Last week, the three-month borrowing cost on overseas dollar deposits recorded its biggest weekly rise since mid-August in the start of the current global credit crunch.
The Fed and other central banks have enacted a number of maneuvers to inject cash into the global money system. But those liquidity moves have been mitigated by the ever growing losses suffered by Wall Street and banks worldwide due their mortgage investments that soured during the U.S. housing slump.
Reporting by Richard Leong; Editing by Leslie Adler