Central banks inject billions into markets but Fed holds US rates

The Federal Reserve continued its tough-love policies toward the US financial system yesterday, saying "no" to Wall Street calls for an interest rate cut, but joining with fellow central banks to provide additional liquidity to rattled markets.

Holding US rates steady at 2 per cent, the Fed's open market committee issued an uncompromising statement saying that it was already doing enough to pick up the US economy: "Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth. The downside risks to growth and the upside risks to inflation are both of significant concern to the committee."

The Fed did, however, note that strains in financial markets have increased significantly, and it reiterated that tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters.

Wild swings on global markets contributed to a febrile atmosphere yesterday, with financial shares on both sides of the Atlantic trading erratically as rumours circulated about the fate of AIG, the giant credit insurer. Some reports said it would declare bankruptcy if a rescue was not arranged by the end of the day, but later hopes grew for a government bail-out. With the unwinding of Lehman Brothers already putting a considerable strain on the credit markets, bond traders had priced in at least a quarter-point cut in US interest rates, and perhaps more.

Bill Gross, founder of the influential fixed-income fund management firm Pimco, called the Fed's reference to ongoing inflation pressures an "other-worldly statement". He said: "Some Fed governors are on another planet, clearly we arein a deflationary environment."

Traders on the floor of the New York Stock Exchange booed the decision when it was released, and the Dow Jones Industrial Average plunged 100 points in the moments afterwards, but it recovered quickly and closed up 141.5, or 1.3 per cent, at 11,059.02. Contributing to the rally were investors who were happy to see that near-panic on the markets was not causing panic at the Fed.

The US has already cut rates from 5.25 per cent a year ago as the credit crisis has worsened, and the Fed has taken a string of extraordinary measures to add liquidity to financial markets, which continued yesterday morning. For the second day in a row, it joined with other central banks around the world to organise additional loans to their country's credit markets. The Fed injected $50bn (£28bn) and said it stood ready to do more if needed later in the day. The European Central Bank allotted €70bn (£55.5bn) in one-day loans, on top of the €30bn it put in on Monday, and the Bank of Japan also acted.

In the UK, the Bank of England injected £20bn of money into the financial system to help counter the rocketing cost of borrowing between banks. The overnight sterling Libor fix – which measures the rate banks lend to each other, and whose rise is a signal of distress in the credit markets – jumped to 6.79 per cent from 5.49 per cent the day before. The cost for banks of borrowing sterling for three months rose to 5.715 per cent from 5.704 per cent. The cost of borrowing dollars overnight more than doubled to 6.43750 per cent, the highest since January 2001.

The £20bn auction was over-subscribed, attracting bids for £58bn from banks hungry for liquidity. On Monday, an auction of £5bn was also heavily oversubscribed. Banks are hoarding liquidity in case AIG followed Lehman Brothers in going bust, leaving financial institutions with losses on $441bn of credit derivatives issued by the insurer.

Fears for the stability of the financial sector caused the FTSE 100 to plunge 3.4 per cent to 5,025.6, after dipping below 5,000 for the first time in three years. HBOS, the UK's biggest mortgage lender, led the fall, dropping 22 per cent to a new all-time low closing price of 182p, after dropping 41 per cent earlier.

Concern that panic might spread from markets to customers drove HBOS and the Financial Services Authority to issue statements saying the owner of Halifax and Bank of Scotland had a strong capital position and was funding itself satisfactorily in the market.

Markets stunned by Lehman's bankruptcy and the crisis at AIG priced in higher risk of financial companies defaulting on their debt. The cost of buying derivatives insuring against defaults at Morgan Stanley, Goldman Sachs and Citigroup soared to a record. The risk of European banks defaulting on their debts rose above that for non-financial companies for the first time since March, previously considered the worst month of the credit crunch.

"We are seeing history in the making and it is a scary sight," Marco Annunziata, chief economist at Unicredit Markets, said in a report. "The US Treasury's decision to opt for shock therapy, allowing Lehman to go bankrupt, has pushed us into uncharted waters."

Fears about the damage the financial turmoil would wreak on the global economy caused the price of oil to tumble. Crude oil fell $4.56 to settle at $91.15 a barrel in New York.