The chaos in money markets since Monday added to Fed policymakers' list of concerns that is already heavy on risks from US-China trade tensions, a weakening global economy and sluggish domestic inflation.

Fed officials began a two-day policy meeting on Tuesday and are widely expected to cut the central bank's policy rate by a quarter of a percentage point.

The surge in borrowing costs, which banks and Wall Street pay to raise cash to fund their trades and loans, also exposed cracks in money markets left by the Fed's normalisation of its massive balance sheet that ended in July, analysts said.

The central bank amassed holdings of Treasuries and mortgage-backed securities during three rounds of quantitative easing (QE) after the financial crisis. Reduction of those holdings was at least partly responsible for a nearly $US900 billion decline in bank reserves since 2017.

"The root cause is the shortage of reserves," said Gennadiy Goldberg, senior interest rates strategist at TD Securities in New York. "This is a funding squeeze."

At one point on Tuesday, overnight borrowing costs in the $US2.2 trillion repurchase agreement market spiked to as high as 10 per cent.

In the repo market, banks and Wall Street dealers use securities as collateral to obtain cash from money market funds and other cash investors.

Another alarming signal was a jump in the average federal funds rate, which the central bank aims to influence. It reached 2.25 per cent on Monday, which matched the upper end of the Fed's current target range and was a move not seen since the height of global credit crisis more than a decade ago.


Analysts attributed for the spike on Monday in repo rates.

Compounding this precarious backdrop was likely a flood of Treasuries dumped on dealers due to last week's dramatic global bond market sell-off, analysts said.

By early Tuesday, there were no signs cash had returned to money markets.

"This increased the pressure on the Fed to doing something," Goldberg said.

The Fed embarked on a move it last deployed on a large-scale since 2008 during the height of the global credit crisis. Repo rates dropped to zero after the Fed announcement before ending the day at about 2.0 per cent, analysts said.

Now, analysts expect the Fed to do more to calm money markets including a standing repo facility, a decrease on what it pays on excessive reserves and/or an increase of its purchases of Treasuries.

Jeffrey Gundlach, chief executive of DoubleLine Capital, told Reuters that the Fed will embark "pretty soon" on "QE lite", in order to increase the money supply and spur lending and investment.

Reuters