Fed's Pianalto touts new tools for tougher times

By Ros Krasny

DAYTON, Ohio (Reuters) - The Federal Reserve was forced to broaden its policy arsenal in order to minimize the effects of the U.S. credit crisis on a vulnerable economy, Cleveland Fed President Sandra Pianalto said on Thursday.

In a speech that largely avoided discussion of the economy's current state, Pianalto said traditional policy mechanisms were not adequate to address worsening credit conditions.

"All of these innovations are designed to bolster market liquidity and promote orderly market functioning," she said. "Liquid, well-functioning markets are essential for promoting financial stability and economic growth."

Since the crisis first erupted last summer, the Federal Reserve has not only slashed interest rates by 3 full percentage points, but also pumped hundreds of billions of dollars into the ailing financial system.

In addition, the Fed has taken the very unorthodox step of accepting depreciated mortgage-backed bonds as collateral for short-term lending, a move that some fear may put the central bank in a difficult position over time.

The Fed also directly funded J.P. Morgan's buy-out of Bear Stearns, which prevented the troubled investment bank from filing for bankruptcy, an event that analysts say would have had serious knock-on effects in other markets.

Pianalto defended the move, however, saying turbulent times called for extraordinary measures.

"Collectively, these innovations provide for much longer terms of lending, broader types of collateral, a wider class of counterparties and a tighter spread between the primary credit rate and the target federal funds rate," she told the RISE investment forum at the University of Dayton.

(Reporting by Ros Krasny, Writing by Pedro da Costa; Editing by Dan Grebler)