WASHINGTON (Reuters) - The Federal Reserve on Tuesday said it would begin buying the short-term debt many companies use to fund their day-to-day operations, its latest emergency move to try to restore credit flows and protect the economy.

The central bank is creating a facility to buy commercial paper because investors such as money market mutual funds have increasingly shied away from this form of corporate debt, a damaging economic development.

“The volume of outstanding commercial paper has shrunk, interest rates on longer term commercial paper have increased significantly, and an increasingly high percentage of outstanding paper must now be refinanced each day,” the Fed said in announcing the program with the blessing of the Treasury.

The Treasury believes the Commercial Paper Funding Facility is necessary to prevent “substantial disruptions” to financial markets and the economy, the Fed said.

To support the facility, the Treasury will make a deposit of funds at the New York Federal Reserve Bank, with Fed officials saying the size of the deposit would be substantial.

Officials said the program, which will buy only top-rated commercial paper, would be up and running soon but probably not in a matter of days. Its size would depend on details yet to be worked out with financial market participants, Fed staff told reporters.

Of $1.75 trillion in commercial paper outstanding in August, eligible issuers accounted for $1.3 trillion. But the central bank does not intend to buy anywhere near that amount, the officials said.

UNSECURED DEBT

The central bank’s unusual move to buy debt that is not collateralized could help thaw frozen credit markets.

“It will certainly help to improve confidence in the short-term funding markets,” said Derrick Wulf, a portfolio manager for Dwight Asset Management in Burlington, Vermont. “It’s pretty unprecedented for a central bank to buy unsecured debt.”

But some analysts worried that yet another emergency Fed buying spree, announced a scant four days after Congress approved a $700 billion financial bailout package, smacked of desperation.

“The Fed is back to ‘whack a mole’ again because that’s the problem of the day,” said Bob Andres, chief investment strategist for Portfolio Management Consultants in Philadelphia. “When you scramble, you don’t instill confidence.”

The U.S. stock market, which had opened higher as the Fed’s announcement help calm jittery nerves on Wall Street, soon gave back those initial gains and were down in late-morning trade. Prices for U.S. Treasury bonds fell as investors held back from buying safe-haven government securities.

The Federal Reserve Building is reflected on a car in Washington September 16, 2008. REUTERS/Jim Young

The dollar and yen fell as investor appetite for risk increased, and markets scaled back bets of a big Fed rate cut soon, as indicated by short-term interest rate futures.

The U.S. commercial paper market contracted dramatically for a third straight week last week, according to Fed data, as business lending and borrowing effectively shut down.

The weekly drop was the largest in at least seven years. Over a quarter of the market has disappeared since the start of the global credit crisis in the summer of 2007.

LIQUIDITY BACKSTOP

The Fed said a special-purpose vehicle will be established to buy three-month unsecured and asset-backed commercial paper directly from eligible issuers.

The Fed would buy only the highest-quality commercial paper at a spread over the three-month overnight indexed-swap rate, a measure of anticipated central bank-set interest rates. The debt would have to be secured to the Fed’s satisfaction through a fee, collateral or some other means.

The Fed expressed hope that the new facility, by eliminating risk about whether eligible issuers would be able to repay investors, would encourage resumption of normal term lending in the commercial paper market.

The special purpose vehicle will stop buying commercial paper on April 30, 2009, unless the Fed decides to extend the program. But the Fed said it will keep funding the vehicle until any assets that it holds have matured.