WASHINGTON (MarketWatch) — U.S. credit markets remained extremely fragile Monday, and observers said the Federal Reserve may have to lower its federal funds target rate to inject permanent liquidity into the market and provide investors with more assurances that the central bank will act to keep the economy growing.

Yields on short-term Treasurys plunged on Monday, evidence that fund mangers were parking their cash in the safest and most liquid assets rather than risk them in any asset backed by mortgages or even in the normally sedate commercial paper market.

The yield on the three-month Treasury fell more than a full percentage point at one point, finishing at 3.09%, down 66 basis points on the day and down about 150 basis points in a week. It was the largest decline since the day the market crashed in 1987. See Bond Report.

“The psychotic atmosphere that has gripped the financial markets recently remains in place,” said Tony Crescenzi, chief bond market strategist for Miller Tabak & Co.

“The extraordinary declines in the bills’ rates show the need for liquidity injections, of the permanent type,” Crescenzi said. “The Fed may have to act” to cut its federal funds rate, not just the discount window rate that it lowered on Friday in an emergency move. Read more about Friday’s cut.

Yields on asset-backed commercial paper continued to inch higher on Monday and are now about 80 basis points higher than the least-risky commercial paper, Crescenzi said.

“The theme in short-dated corporate debt remains limited liquidity for second-tier credit borrowers and obligations beyond two-weeks,” wrote David Ader, a bond strategist for RBS Greenwich Capital.

Tell Companies To Stop Price-Gouging American Consumers