Fed Raises Discount Rate to 6% : First Increase in 3 Years; Major Banks Boost the Prime

The Federal Reserve, signaling a tough stance against inflation under new Fed Chairman Alan Greenspan, announced Friday that it is increasing a key lending rate for the first time in three years. The move immediately triggered an increase by major banks in their prime lending rate.

The Fed raised its discount rate, the interest it charges on loans to U.S. financial institutions, from 5.5% to 6%.

The announcement by the Fed on the discount rate was followed almost immediately by announcements from two large New York banks, Chase Manhattan and Chemical Bank, that they were raising their prime business lending rates one-half of a percentage point, from 8.25% to 8.75%, the highest level for the prime rate since March, 1986.

Other Banks Followed

Later in the day, other major banks across the country joined the rush to increase their prime rate.

In a brief statement, the Fed said its decision “reflects the intent of the Federal Reserve to deal effectively and in a timely way with potential inflationary pressures.”

The Reagan Administration, which at times has been critical of tightening moves made by former Fed Chairman Paul A. Volcker, supported Friday’s discount rate increase.

“The Administration concurs with the action of the Federal Reserve Board in raising the discount rate in order to maintain steady economic growth with low inflation,” said presidential spokesman Marlin Fitzwater, with the vacationing President Reagan in Santa Barbara.

“There have been 10 changes in the discount rate since the recovery began. Today’s should keep inflation with the Administration’s mid-session estimate of 4.8%,” Fitzwater said.

Inflation Fears

Allen Sinai, chief economist of Shearson Lehman Bros. of New York, said he believes the Fed decision was taken in an effort to cool inflationary forces stemming from the recent declines in the value of the dollar.

“Anything that helps the dollar helps inflation because the weak dollar is the chief inflationary pressure we have right now,” he said.

The last increase in the discount rate, boosting it from 8.5% to 9%, was announced on April 6, 1984, and took effect three days later. Since then, the rate has been cut seven times, with the last reduction occurring a year ago on Aug. 20, when it dropped from 6% to 5.5%.

The increase in the discount rate came after a three-week slide in the value of the dollar on foreign currency exchanges. Many analysts had expected that the Fed would be forced to act to stabilize the falling dollar by pushing up interest rates in the United States.

Higher rates in this country make dollar-denominated investments more popular with foreigners, who now hold a sizable percentage of U.S. debt.

This interest rate scenario is similar to what happened last spring when investor worries about inflation caused the dollar to decline on foreign exchange markets. This led to a slump in bond markets that pushed interest rates sharply higher.

The Fed’s decision to raise the discount rate was approved on a 4-0 vote with two board members, Martha Seeger and Robert Heller, absent.

The action was the first significant move the central bank has made since Greenspan replaced Volcker as chairman on Aug. 11.

Most Dramatic Move

An increase in the discount rate is the most dramatic move the central bank can make to signal its intentions to push rates higher as a way of keeping a curb on inflationary pressures in the economy.

One of the major forces that has been pushing up prices this year has been the falling dollar, which boosts the cost Americans must pay for foreign products.

The Reagan Administration, beginning in September, 1985, pursued a policy of pushing the dollar lower as a way of reducing the huge U.S. foreign trade deficits. Administration officials hoped that higher costs for imports would reduce Americans’ appetite for foreign products while at the same time making U.S. products more competitive on overseas markets.

While this strategy appears to be working, the turnaround took much longer than expected and has a downside of increasing inflationary pressures in the United States.

Economists had said that one of the key problems Greenspan would face in his early months as Fed chairman was what to do to defend the dollar if it began falling again.

Economists said the financial markets would be closely watching to see whether Greenspan acted to tighten credit conditions to dispel any fears that he might not be as independent of political pressures from a Republican White House as Volcker was.