Credit Squeeze Tightens Grip

The Fed, for its part, was trying to prevent markets from "completely freezing," says Ethan Harris, chief economist at Lehman Brothers.

"Given the high level of attention focused on the coming year end, we hope to reassure market participants of our commitment to providing sufficient balances at that time by starting to provide those balances now," said a New York Fed official.

The Fed also reassured markets by noting that its trading desk "plans to provide sufficient reserves" to battle upward pressures on the federal funds rate. In other words, the Fed will provide liquidity to the market to keep banks lending to each other at the Fed's current target rate of 4.5%. According to the New York Fed Web site, the effective fed funds rate, or the real rate at which banks have been lending to each other has been elevated for the past two weeks. That means banks are hoarding cash in an unpredictable market environment, anxious about their ability to maintain reserves, and charging premiums to other banks for overnight money.

"There's definitely a scramble for liquidity," says Harris. "We're far from out of the woods in terms of this difficulty in capital markets."

The Fed's reassurance comes as banks and other financial institutions face a year-end pinch for capital as they attempt to cleanse their balance sheets of their most unsavory assets before reporting final results.