Washington: The government is weighing a bold plan to buy massive amounts of unsecured short-term debts in a dramatic effort to break through a credit clog that is imperiling the economy.
The Federal Reserve is working with the Treasury Department on the plan to buy “commercial paper,” a short-term financing mechanism that many companies rely on to finance their day-to-day operations, such as purchasing supplies or making payrolls, according to a person with knowledge of the plan. The person spoke on condition of anonymity because the plan is still being put together.
The market for this crucial financing, which relies on investors rather than banks, has virtually dried up. That has made it increasingly difficult and expensive for companies to raise money to fund their operations. Commercial paper is a way of borrowing money for short periods, typically ranging from overnight to less than a week.
The unstable situation has left many companies vulnerable. The notion under the plan is for the government to come up with a backstop that would provide companies with a new place to get cash. Depending on the ultimate shape of the plan, the Fed could become a source of credit for nonfinancial businesses in addition to commercial banks and investment firms.
The Fed made an opaque reference on Monday that it was exploring “ways to provide additional support” to “unsecured funding markets.”
The creation of a separate legal entity was being examined as one way for the Fed to get into the commercial paper market, the person familiar with the plan said.
The Fed pledged Monday to take “additional measures as necessary” to battle the worst credit crisis in decades. Wall Street took a nosedive, with the Dow Jones industrials plunging more than 800 points at one point during the day before finishing down 370. Fears spread around the globe about the ability of policymakers in the United States and abroad to turn around the situation.
The lending lockup is a key reason why the U.S. economy is faltering. Unable to borrow money freely or forced to pay a high cost to borrow, employers are cutting jobs and reducing capital investments. Consumers have retrenched.
To help ease credit stresses, the Fed announced Monday it will provide as much as $900 billion in cash loans to squeezed banks. It said 28-day and 84-day cash loans being made available to banks will be boosted to $150 billion apiece. Those increases will eventually bring the amounts outstanding under the program to $600 billion.
Loans that will be made available in November to banks also will be increased to $150 billion each. That makes a total of $900 billion in credit potentially outstanding over year-end, the Fed said.
The Fed also said it will begin paying interest on commercial banks’ reserves, another way to expand the central bank’s resources to battle the credit crisis.
In the $700 billion bailout bill President George W. Bush signed Friday, Congress gave the Fed the power to pay interest on those reserves for the first time. The law accelerated the effective date to Oct. 9 of this year, rather than October 2011.
The move also will encourage banks to keep excess reserves at the central bank because they will now be earning interest on the money. That will help give the Fed more control over interest rates and more leverage to battle the credit debacle. Under the current formula, the Fed would pay interest of roughly 1.25% on excess reserves. A different rate would be paid for required reserves.
“Together these actions should encourage term lending across a range of financial markets in a manner that eases pressures and promotes the ability of firms and households to obtain credit,” the Fed said.
A growing number of economists and investors believe the Fed will be forced to do an about-face and lower its key interest rate, now at 2%, on or before its next meeting on 28-29 October.
Such a move would revive the central bank’s rate-cutting campaign, which had been halted in June out of concerns that those low rates would worsen inflation. Since then, however, economic and financial conditions have dangerously deteriorated, while inflation pressures have calmed a bit.
Any reduction to the Fed’s key rate would cause a corresponding drop in commercial banks’ prime lending rate, now at 5%. The prime rate is used to peg loans to millions of consumers and businesses.
The hope riding on such a move by the Fed would be to spur nervous consumers and businesses to spend more freely again.