Even though credit market turmoil appears to be abating, the elevated level of the U.S. federal funds rate shows that the short-term lending market is not yet out of the woods.

So far this week, fed funds, the main U.S. short-term overnight lending market among banks, have traded at their session highs above 6 percent, or a full 75 basis points above the 5.25 percent target rate the Federal Reserve sets.

In spite of major stock indexes ending the week up around 1 to 2 percent, and a modest drop of LIBOR or the London Interbank Offered rate, distortions in the fed funds market appear to belie the notion that the Fed's huge injections of liquidity have restored business as usual to money markets.

"You are still seeing large intraday swings," said Lou Crandall, chief economist at Wrightson ICAP, in Jersey City, New Jersey.

The average federal funds rate "hasn't settled down into a stable trading pattern yet and there is probably not much chance it will do until after the Fed meeting, once you take away the anticipation of an imminent rate cut," Crandall said.

Fed policymakers next regularly scheduled meeting is on Tuesday, at which investors expect either a 25- or 50 basis points cut in the fed funds target rate. That would be the first interest rate reduction by the Fed in four years.

"It is clear from the pattern of the past 6 weeks that the Fed's job in balancing reserves in a way that fits and produces the 5.25 percent target rate has become more difficult because of the many factors coming into play recently with the supply of money," said Tony Crescenzi, chief bond market strategist, at Miller, Tabak & Co. in New York.

Since the credit market crisis took off in early August, the Fed has pumped some $243 billion of temporary reserves into the banking system, quantities not seen since the aftermath of September 11, 2001's attacks on the United States.

Going back to August 9, when global central banks started flooding financial systems with cash to prevent a complete shutdown of credit markets, the actual rate at which U.S. banks are providing each other overnight funds, the fed funds effective rate, has averaged near 5 percent, according to Federal Reserve data.

That's equivalent to the 25-basis-point reduction in the fed funds target rate that many investors expect on Tuesday.

But some analysts reckon the rebound of fed funds over the past few days show the Fed is still unable to steer the overnight lending market to trade within a handful of basis points of the target rate, as would be typical in calmer markets.

Others reckon the Fed has allowed federal funds to rise above 6 percent in late trade, above the 5.75 percent discount rate, to nudge banks into borrowing directly from the Fed via the discount window.

"It's intentional and engineered to make banks approach the discount window and make banks use that as their means of financing," said Kenneth Kim, economist with Stone & McCarthy Research Associates, in Princeton, New Jersey.

The Fed cut the discount rate on August 17, to encourage banks to borrow from the window.

"The reason the Fed wants to make banks approach the discount window is that banks don't have counterparty risk by borrowing directly from the Fed as opposed to from each other in the fed funds market, where some questions have arisen as to whether you may get your funds back," Kim said.

Any doubts that banks might be hesitant to use discount borrowing were dispelled by data on Thursday that showed banks more than doubled their requests for cash at the Federal Reserve's discount window last week. That pushed borrowings to their highest levels since the days following the September 11, 2001 attacks.

These efforts to shift bank borrowing from one area of the markets directly to the Fed's own accounts, Kim adds, reflect uncertainty and the possibility of contagion.

Crandall allows for the possibility that volatile market behavior may be the main reason for swings in fed funds.

Also a rise in federal funds on Wednesday may have been partly driven by the end of a two-week maintenance period, analysts add. By that date, banks have to amass the requisite amount of reserves, which can push the cost of overnight borrowing in federal funds up above the target rate.

Or, assuming the Fed has engineered a rise in fed funds over the past week, there could be several explanations, Crandall offers.

"They want to hit their target rate, or they deliberately want to get discount borrowing up," he said.

"Or if you want to make a rate cut look like a rate cut (in the target rate) you have to get the funds rate back up," Crandall said.

"If they didn't get funds above 5 percent before the Tuesday FOMC policy meeting, they run the risk that people would look at the fed funds target rate and say: 'that's a tightening'," Crandall added.

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