Fed lowers discount rate to 5.5 percent Move intended to end continuing economic slide

May 01, 1991|By Thomas Easton | Thomas Easton,Sun Staff Correspondent

WASHINGTON -- Responding to continuing evidence of a contracting economy as well as receding fears of inflation, the Federal Reserve Board cut the discount rate, its most visible tool of policy, from 6 percent to 5.5 percent yesterday.

The discount rate -- the rate the Fed charges on direct, short-term loans to banks -- is now at its lowest level since 1977 with the exception of an interval from August 1986 to September 1987. Yesterday's reduction is the third since December, suggesting an unusually aggressive approach by the Fed to use lower interest rates to reinvigorate business.

While in practice few banks ever avail themselves of direct Fed borrowing unless under extreme duress, the rate is a blunt message from the nation's central bank to the banking community of the direction it intends to push other rates.

And cuts in the discount rate are typically accompanied by more subtle but even more powerful measures, such as direct steps to expand the money supply.

Reflecting this, the so-called federal funds rate -- the rates banks charge for overnight loans to each other -- fell from 6 percent to 5.75 percent, and the rate on the bellwether 30-year Treasury bond dipped slightly, from 8.22 percent to 8.19 percent.

The decision to reduce the discount rate comes as a series of disconcerting statistical reports on the economy have dimmed hopes that a quick Persian Gulf war victory could provoke an tTC equally abrupt end to the recession.

Yesterday, the Commerce Department announced that factory orders, a primary indicator of economic activity, had fallen for the fifth straight month, with the decline spread between expensive durables such as trucks and machines and non-durables such as chemical and petroleum products.

Apparently swayed by the report, an official statement released by the Fed along with the announcement of the rate cut said that "action was taken in light of continuing weakness in economic activities, especially in the industrial and capital goods areas."

Coming on the heels of so many gloomy economic indicators, the direction of yesterday's action by the Fed was expected.

"It was inevitable," said Douglas Handler, an economist with Dun & Bradstreet Corp.

But the timing came as a surprise to many Fed watchers. Many expected that the Fed would wait at least until it received employment numbers at the end of this week before making a move. "What's the rush?" said Edward Yardeni, an economist with C. J. Lawrence, a Wall Street investment firm.

"The fact that it eased today is a little worrisome," Mr. Yardeni said. "The message seems to be they are getting a little panicky."

In making the cut, the Fed cited "evidence of abating inflationary pressures," which apparently gave it room to reduce rates without fearing any surge in money would merely be reflected in higher prices rather than increased economic activity. The broad advance of the bond market suggested the move was well received by an audience that is highly sensitive to any sign of inflation.

The move also was well received on Wall Street -- where the market rallied strongly after the announcement, though it weakened later -- and by the Bush administration. "We are encouraged by the action the Fed took today and applaud them," said Robert Glauber, Treasury undersecretary for finance.

Shortly after the early morning announcement of the discount rate cut, the Southwest Bank of St. Louis reduced its prime lending rate, or the rate extended to customers with the best credit, to 8.75 percent from 9 percent, and Mr. Glauber suggested that other banks were likely to follow -- "eventually".

But how quickly that occurs remains questionable. Because of persistent problems stemming from poor loans, banks have attempted to rebuild their profitability by only belatedly passing on their lower cost of funding.

"Typically, there's a lag, but this time banks have been very, very slow," said James Fralick, an economist with Morgan Stanley & Co. As evidence, he noted that the spread between what an individual may get for investing in a three-month bank certificate of deposit and the rate a top customer pays on a loan is about 50 percent higher than normal.

And whether the rate cuts, even when they are eventually passed on to borrowers, are enough to restimulate growth remains in question. After all, rates have been declining since last fall without sparing the country from a recession.

"There is clearly reason to show concern that the economy has not shown life to date despite earlier rate cuts," Mr. Yardeni said.

Added Mr. Handler, "I don't think it will materially help the economy, but it's a symbolic move, and it will help push things in the right direction."

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