NEW YORK, Dec 18 (Reuters) - Rates banks charge each other for U.S. dollar-denominated funds slid to fresh 4-1/2 year lows on Thursday in the wake of the U.S. Federal Reserve's move this week to keep interest rates at rockbottom levels for a sustained period.

 

The Fed's dramatic measure that sent its target rate to a record low range of zero to 0.25 percent has helped to unlock credits for cash-strapped borrowers, but it has not been the immediate jolt that some traders had hoped.

 

"Fed action is mitigating the damage to the financial system, but not completely reversing it," said T.J. Marta, fixed income strategist with RBC Capital Markets in New York.

 

Liabilities on the U.S. Federal Reserve's balance sheet, stemming from its multiple rescue efforts for the financial system, rose to a fresh record of $2.295 trillion in the latest week, Federal Reserve data showed on Thursday.

 

However, the U.S. banking sector's borrowing from the central bank slipped to an average $212.53 billion per day in the latest week from $240.59 billion the week before. Banks are still heavily reliant on cheap Fed cash to stay afloat but there are tentative signs that the deep inter-bank lending freeze caused by the global credit crisis is starting to thaw.

 

Three-month dollar rates in London dropped to 1.52500 percent at the British Bankers Association's London fixing on Thursday from 1.57750 on Wednesday, extending the fall in the past week to more than 60 basis points and hitting its lowest levels since mid-2004.

 

The equivalent euro and sterling Libor rates also eased.

 

The three-month Euribor rate -- traditionally seen as the main gauge of the bank-to-bank euro lending market -- fell to 3.125 percent, the lowest level since July 2006, as 175 basis points worth of recent interest rate cuts by the ECB continued to depress interbank rates.

 

While the ECB weighs further policy easing, the Bank of Japan is expected to lower rates from the current target of 0.30 percent.

 

The spread between three-month dollar Libor and overnight index swaps eased to 133 basis points from 141 bps the previous session -- a sharp narrowing from 191 bps last week.

 

Risk premiums in in the interbank market and other credit sectors, while falling in the past two days, are still running above their historic averages, analysts said.

 

Market aversion remained high with intense demand for cash and safehaven government debt. U.S. Treasury bill rates traded near zero, as investors were willing to surrender yields in exchange for stable, low-risk assets.

 

"It's a bet to get your money back even if you are not earning anything," said Eric Lascelles, chief economics and rates strategist at TD Securities in Toronto.

 

Despite lingering anxiety, there are signs of continued improvement in some critical areas of the credit market.

 

In the U.S. commercial paper sector, which many companies rely on for short-term funds to finance their operations, the amount of this type of debt outstanding rose for an eighth straight week to $1.709 trillion.