Fed Action on Discount Rate Remains Unclear

The latest banking data leave no doubt the Federal Reserve has tightened credit another notch, but leave open to question whether the central bank will immediately raise the discount rate.

Kristin Foster of Citicorp said a key piece of evidence confirming a move to tighten credit was that the Fed had no errors in its reserve projections in the latest week. Therefore, recent open market operations were intended to raise the federal funds rate and were not the result of an error in estimating banking system reserves.

“Obviously they have tightened,” Foster said. “There’s no doubt they’ve raised their borrowing and funds rate targets.”

The huge upward revision Thursday in real first-quarter gross national product to 3.9% from a previously reported 2.3% topped the most optimistic forecasts and spread talk of an imminent discount rate increase like wildfire through the financial markets. The discount rate is the rate at which the central bank lends to commercial banks and serves as a floor on interest rates.

Discount rate fever was especially heated given that a three-day U.S. holiday weekend loomed, and the Fed last raised the discount rate to 6% from 5.5% on Sept. 4, 1987, the day before the three-day Labor Day weekend.

While not ruling out the possibility of an imminent rate increase, many analysts say it is still too soon for the Fed to act.

“The obvious reason for no discount rate increase now is that they want to save that ammunition for any potential problem in the dollar, or for when they see much stronger economic growth,” said Harold Nathan of Wells Fargo Bank.

The irrepressible GNP growth seen for the last two quarters argues for a discount rate increase to 6.5%, he said. But problems in the farm credit system, at savings and loan associations and Texas banks still argue for small cautious steps to tighten policy.

“They will gradually keep tightening, as second quarter will be strong too, but they won’t raise the discount rate,” Nathan said.

Joe Liro of S. G. Warburg Securities Inc. says a discount rate increase is likely if next week’s report on May U.S. non-farm payrolls shows another hefty gain.

If employment is strong again, the fed funds rate, which is the rate banks charge each other for overnight loans, will rise to 7.5%, prompting a round of prime rate increases by U.S. banks.

“Then the Fed will raise the discount rate, and can say it was following, not leading the markets,” he said.

Concern over the U.S. discount rate affected overseas markets Friday.

The Hong Kong and Tokyo stock markets closed lower on investor worry that the United States would raise interest rates. Such exporting nations as Japan worry that higher U.S. rates will lead to a slowing of U.S. imports.