Fed Slashes Its Discount Rate to 5.5% : Reduces Interest to Nine-Year Low to Spur Economy
The Federal Reserve Board, reacting quickly to Tuesday’s announcement of the economy’s feeble quarterly growth rate, said Wednesday that it is cutting the discount rate from 6% to 5.5%, the lowest level in nine years.
The seven-member board said it acted unanimously on requests submitted from 10 regional Federal Reserve banks and did so “in the light of prevailing economic and financial circumstances.” Chief among those was the weak record of 0.6% real growth during the second quarter of the year, reported Tuesday by the Commerce Department.
Fourth Cut This Year
The Fed action to reduce the key rate it charges financial institutions, effective today, is the fourth such cut this year and brings the rate to its lowest point since the end of August, 1977, when the rate was raised half a point to 5.75%. The discount rate, the only interest rate directly controlled by the Fed, significantly influences rates charged by lending institutions and earned by investors. The Fed apparently hopes that lower interest rates will boost economic activity by encouraging consumer and business borrowing.
Economists saw the move as forced by continuing weak growth and by a persistent trade deficit, and they pointed out that it apparently was taken without any agreement by either West Germany or Japan, key U.S. trading partners, to reduce interest rates there.
Allen Sinai, chief economist with Shearson Lehman Bros., predicted that the impact on short-term market rates would be almost instantaneous.
Prime Rate Should Drop
The prime rate, the benchmark by which banks determine most of their lending rates, should drop 0.5 points to 7.5% “immediately,” Sinai said. The federal funds rate, the overnight rate among banks, should stabilize at about 5.75%, he predicted, with the rate on 90-day Treasury bills dropping slightly, to about 5.25%.
However, if there is no backup action by West Germany or Japan to cut their interest rates, he said, long-term rates may not move at all.
The Fed “acted unilaterally out of fear of fading growth,” Sinai said. “Right now, waiting for our trading partners to cut rates is like waiting for Godot. It makes no sense.”
In fact, Sinai said, the economy may be better off in the short term if the West Germans and Japanese continue to hold aloof from concerted interest rate reductions, by ensuring that the deutsche mark and yen remain strong relative to the dollar. “After yesterday’s GNP report, it is crystal clear that we need a trade improvement and need it fast,” he said.
But Frank McCormick, a senior economist with Bank of America, disagreed on this point. He said he believes the likelihood that either Japan or West Germany will order a rate cut within a week or two is “about 65%.”
McCormick noted that both agreed to cut rates in concert with the United States on March 7 and that Japan cooperated on April 18. Thus, in recent months, the Fed was forced to act unilaterally only on July 10, with the reduction from 6.5% to 6%.
Kathleen Cooper, chief economist at Security Pacific National Bank, agreed that “we were the leader on this one.”
She added that “this should be the last cut for a while,” noting that the accumulated discount rate cuts of 2 percentage points since the beginning of the year are expected to begin to lift the slowing economy eventually.
By acting within a day of this week’s meeting of the Fed’s Open Market Committee, the board did what most economists had assumed it would have to do, but perhaps a week or two sooner than expected. Partly for that reason, some economists--who a month ago said they believed that the July 10 rate cut to 6% was too small and too late to give much boost to the economy--saw more reason for optimism this time.
Indeed, Bank of America’s McCormick said he believes the economy is actually stronger than Tuesday’s weak gross national product report made it appear.
“If you look at the four quarters that ended before April, 1986, the economy grew at a rate of 3.1%,” he said. “That is a respectable rate of growth and the weakness in the second quarter was more a matter of inventory sell-off than trade. The downward revision in trade took off only another 0.5% from the GNP figure, but inventories took off 3.1% from real growth. That is even a healthy sign for the future.”
But the Fed itself clearly signaled concern for economic growth in the one-sentence announcement late Wednesday of its decision. “In the light of prevailing economic and financial circumstances, the action appears consistent with the objective of sustaining orderly growth within a framework of greater price stability,” the statement said.
Sinai said: “That means growth is the bottom line, and inflation is no problem.”
