Fed auction to be watched for signs of credit market distress

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The Federal Reserve will today continue its unprecedented efforts to prop up the credit markets, in what is set to be one of its most closely watched auctions of new debt.

The Fed began offering cheap loans to the financial markets in December as part of a co-ordinated series of measures by international central banks aimed at easing the credit crisis, and it has now loaned more than $130bn to Wall Street firms at fortnightly auctions, far outstripping the $40bn it initially said it was willing to offer.

It is auctioning a further $30bn tranche of debt this morning at a minimum interest rate of 2.81 per cent, making it cheaper than the 3 per cent rate that banks typically lend to each other. The money will be due for repayment in 28 days.

The Fed is stepping in as lender of last resort because Wall Street institutions, fearful of losses and hoarding money to prop up their own battered balance sheets, have become notably more reluctant to lend to each other.

The Fed, along with the Bank of England and the European Central Bank, have expanded the sorts of investments that they accept as collateral for these short-term loans, making it easier for Wall Street banks to borrow and reducing the stigma of doing so. The Bank of England said in December it was going to make £10bn available in three-month loans, but that this money would be diverted from other lending operations.

Today's auction comes after new flare-ups across the credit markets since the start of February, which have jacked up the interest rates being paid by investors, companies and local government, and threatening to cause significant damage to an already weak US economy.

Debt-market players will be keen to see the level of demand in the Fed auction, looking for clues as to the level of distress being felt by Wall Street banks after months of multibillion-dollar losses on sub-prime mortgages and other exotic credit instruments.

Many observers expect interest in the auction could be keener than ever, in line with other types of borrowing from the Fed. Last week, US banks borrowed from the Fed's "discount window" at a pace not seen since mid-January. The Fed lends money at a punitive interest rate at its discount window, and interest had waned since the much cheaper auction facility was introduced in December.