The Federal Reserve kept its target for the federal funds overnight rate at 2 percent today, even as the rate banks actually charge each other for overnight or short-term loans soars over fears related to continued turmoil in financial markets.

If the Fed and European central banks are unable to ease those fears by loosening the reins on the money supply, interest rates on many adjustable-rate mortgage (ARM) loans tied to the federal funds and London Interbank Offered Rate (LIBOR) could soar, leading to more delinquencies and foreclosures.

The Federal Reserve kept its target for the federal funds overnight rate at 2 percent today, even as the rate banks actually charge each other for overnight or short-term loans soars over fears related to continued turmoil in financial markets.

If the Fed and European central banks are unable to ease those fears by loosening the reins on the money supply, interest rates on many adjustable-rate mortgage (ARM) loans tied to the federal funds and London Interbank Offered Rate (LIBOR) could soar, leading to more delinquencies and foreclosures.

Many home equity loans are tied to the federal funds rate, and most subprime and many prime ARM loans are tied to LIBOR. Some 6 million U.S. mortgages are tied to LIBOR, Bloomberg reported, citing data from First American CoreLogic.

While the Fed and other central banks can influence short-term rates by loosening or tightening money supply, the rates are ultimately determined by the market.

The effective federal funds rate leapt to 6 percent Monday, a day when the Dow Jones Industrial Average had its worst day since trading resumed after the Sept. 11, 2001, terrorist attacks. The Dow fell more than 500 points after the investment bank Lehman Brothers filed for Chapter 11 bankruptcy and insurer AIG struggled to raise capital to stay in business.

The Fed attempted to bring the federal funds overnight rate back down to its target of 2 percent Monday by injecting $70 billion into money markets through repurchase operations, Bloomberg said, but the overnight LIBOR rate was up 3.33 percentage points to 6.44 percent today, the largest increase in seven years.

Central banks, including the Bank of England, the U.S. Federal Reserve and the European Central Bank set official base rates, but LIBOR reflects the actual rate at which banks borrow money from each other in 10 currencies for durations ranging from overnight to 12 months.

In a statement, the British Bankers’ Association acknowledged that "in the current uncertain market conditions, banks are looking to their own liquidity as the priority." In other words, banks are less willing to lend money to other banks — even overnight — except at substantially higher rates than than just a week ago.

Such volatility in short-term rates is usually temporary, but financial analysts are concerned about the implications of a prolonged increase in LIBOR, which is used to set rates for financial products worth about $350 trillion.

The British Bankers Association recently announced changes in the way it reports LIBOR in response to allegations that some banks were underreporting the actual rate they charged for overnight loans in order to keep the published rate lower.

Loosening the supply of money reduces the cost of borrowing, but can also spur inflation. In a unanimous vote to keep the federal funds overnight rate at 2 percent, the Federal Reserve Open Market Committee said the inflation outlook remains "highly uncertain."

"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," the committee said in a statement. "Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth."

The Federal Reserve Open Market Committee made seven consecutive cuts to its target for the federal funds rate between September 2007 and April 2008, bringing it down from 5.25 percent to 2 percent. European central banks have made similar moves to encourage borrowing. According to Bankrate.com, the one-month LIBOR rate was 2.49 percent for the week ending Sept. 10, down from 5.5 percent a year ago.

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