WASHINGTON (Reuters) - The Federal Reserve on Tuesday announced it would create a special-purpose facility, with the Treasury Department's blessing, to begin buying commercial paper in yet another emergency move aimed at calming chaotic financial markets.

The central bank said it was acting because money market mutual funds and other investors have become increasingly reluctant to buy commercial paper, which is widely issued to provide vital funds for day-to-day business operations at many companies.

"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.

Treasury believes the facility is necessary to prevent "substantial disruptions" to the financial markets and the economy, the Fed said in a statement.

Treasury will make a deposit of funds at the New York Fed to support the facility, though the Fed did not specify the size of the deposit.

The central bank's unusual move, with Treasury backing, to buy debt that is not collateralized might help thaw frozen credit markets, an analyst said.

"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, Vt. "It's pretty unprecedented for a central bank to buy unsecured debt."

The facility gave a surge of relief to shell-shocked investors as the trading day began on the U.S. stock market. Stock indexes jumped and the dollar strengthened against the yen and euro on the announcement. Treasury bonds fell sharply and interest rate futures markets scaled back bets of a big Fed rate cut soon.

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.

The Fed said its new commercial paper funding facility (CPFF) would act as a liquidity backstop for U.S. issuers of commercial paper. A new special-purpose vehicle (SPV) will be established to buy three-month unsecured and asset-backed commercial paper directly from eligible issuers.

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

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

(Editing by Chizu Nomiyama)

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