WASHINGTON – The Federal Reserve on Wednesday announced a novel approach to injecting money into the banking system as it struggles to combat a severe credit crunch that threatens to drag the country into a recession.
The Fed said it would conduct two auctions next week where banks can bid for up to $40 billion in loans, money that they will have to bolster their own reserves. It marked the Fed’s biggest concentrated effort to inject liquidity into the banking system since the Sept. 11, 2001, terrorist attacks.
The hope is that the extra funds will spur increased lending on the part of the banks and combat a serious credit crunch that has made loans harder to obtain for many businesses and consumers.
The announcement initially lifted spirits on Wall Street, with the Dow Jones industrial average up as much as 272 points in early trading.
However, stocks could not hold on to most of those gains as investors began to worry that the Fed’s new auction plan wouldn’t be enough to deal with the worsening credit crunch. The Dow finished the day up only 41.13 points at 13,473.90.
That performance followed a huge 294-point drop in the Dow on Tuesday as investors expressed disappointment at what they viewed as a timid interest rate cut by the Fed. The central bank trimmed its federal funds rate, the interest that banks charge each other, by a quarter-point. It was the third cut since September, but many investors had been hoping for a bolder move on the part of the Fed.
The Fed linked the new auction process to an announcement that it was extending a line of credit in dollars to the European Central Bank and the national bank of Switzerland so that those institutions could better deal with credit problems in Europe. The Fed said it was also coordinating with the central banks of England and Canada.
The efforts are seeking to restore confidence that Federal Reserve Chairman Ben Bernanke and his colleagues at the Fed and the monetary authorities in other countries are doing enough to deal with the spreading global credit crisis.
“They are trying to help hard-pressed banks raise much-needed cash. The banking system is under severe pressure because the banks don’t want to lend to each other,” said Mark Zandi, chief economist at Moody’s Economy.com.
The Fed’s new program will begin with two auctions next week and another two in January. The first auction for up to $20 billion will occur on Dec. 17, followed by a Dec. 20 auction for another $20 billion.
The Fed is trying the auction program as an experiment to provide another avenue for providing loans to banks because banks have shied away from borrowing from the Fed’s discount window because of the stigma that can be linked to banks who make frequent use of it.
“This is a creative way to try to get more cash into the system without marking anyone as being in trouble,” Zandi said.
In a statement timed before the start of trading on Wall Street, the Fed said it would hold two more auctions on Jan. 14 and Jan. 28. The size of the January auctions will be determined later.
“This is not about particular financial institutions with particular problems. It is about market functioning,” said a senior Federal Reserve official who briefed reporters on condition of anonymity because of the sensitive nature of the actions.