WASHINGTON (Reuters) - The Federal Reserve said yesterday 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 US 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 programme, 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.

The central bank's unusual move to buy debt that is not collateralised 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 US 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 US Treasury bonds fell as investors held back from buying safe-haven government securities.

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.