Federal Reserve Ups Discount Rate : Hike to 6.5% Likely to Trigger Higher Borrowing Costs for Mortgages, Loans
The Federal Reserve, in the most visible step it can take to show its determination to fight inflation, Tuesday raised its discount rate--the interest it charges financial institutions for last-minute borrowings--from 6% to 6.5%.
The move is likely to be followed soon by higher interest rates on home mortgages, business borrowings and some consumer loans, which could have repercussions for November’s presidential election. And if the economy continues to grow strongly, analysts said, the Fed will be under pressure to push rates even higher in the months ahead.
Endorsed as Necessary
Most economists, while surprised by the discount rate hike, endorsed the Fed’s move as necessary to help slow down an economy that appears to be on the verge of an inflation-generating boom. But some analysts argued that there was little threat from inflation at this time and worried that the action might upset financial markets.
The Reagan Administration, while expressing “disappointment” at the Fed’s discount rate hike, went out of its way to avoid any direct criticism of the largely independent central bank.
“We think the Fed’s on the right course,” White House spokesman Marlin Fitzwater said in response to intensive questioning by reporters. “The economy is strong, continuing to create jobs, continuing low inflation. You could try to paint another picture, but you ain’t gonna paint it for me.”
The Fed, which ordinarily discloses such actions after markets close in the afternoon, made Tuesday’s announcement 15 minutes after the stock market opened in New York. Although the Dow Jones industrial average lost slightly more than 28 points on the day to 2,079, it recovered 12 points in less than an hour before the close.
Bond prices tumbled, and the yield from the Treasury’s bellwether 30-year bond jumped to 9.19% from 9.10% late Monday. On foreign exchange markets, the dollar advanced strongly against other major currencies as higher U.S. interest rates attracted more capital from abroad.
The central bank, in a brief statement, said its decision “reflects the intent of the Federal Reserve to reduce inflationary pressures” and “was taken in light of the growing spread of market interest rates over the discount rate.”
Vigorous Growth
Former Federal Reserve officials said the hike in the discount rate--to its highest level in more than two years--seemed timed largely to respond to recent signs that the economy is still growing vigorously. The Labor Department reported last Friday that an unexpectedly large 283,000 jobs were added to non-farm payrolls in July after an explosive gain of 532,000 jobs in June.
Fed officials, who believe the economy needs to slow down from such a strong growth rate to avoid rekindling inflation, also made their move just ahead of this week’s auction of medium- and long-term government bonds.
But coming less than a week before the Republican convention begins in New Orleans, the action also seemed aimed at disproving the contention by some analysts that the Fed was reluctant to make such a dramatic move because it might harm Vice President George Bush’s election prospects in November.
“This sends a signal loudly and clearly that the Fed is not going to let any short-run considerations get in the way of what is in the long-run interest of the economy,” said Lyle Gramley, a former Fed governor who is now chief economist at the Mortgage Bankers Assn.
“I’ve been hearing comments questioning the Fed’s credibility because of political considerations,” Gramley added. “They can’t afford to let people say things that would raise doubts about the Fed’s determination to resist inflation.”
The increase in the discount rate was the second since Alan Greenspan replaced Paul A. Volcker at the Fed’s helm a year ago. On Sept. 4 of last year, the central bank raised the rate to 6% from 5.5%, its recent low point.
While last September’s increase in the rate also was taken in response to inflationary fears, some analysts later cited it as a contributing factor in the Oct. 19 stock market crash.
“I just hope history doesn’t repeat itself,” said Irwin Kellner, chief economist for Manufacturers Hanover Trust Co. “I don’t look for a market collapse, but the crosscurrents of the stock market aren’t very favorable. It certainly is dangerous.”
The vote by the six current Fed governors to raise the discount rate, which followed the recommendations of nine of the regional bank boards, was unanimous.
Until Tuesday’s move, there had been tension inside the Fed between several regional bank presidents, who argued that the central bank needed to move more aggressively to raise interest rates because of the strong economy, and some of the Reagan-appointed board members, who contended there was little indication that inflation was actually accelerating.
Indication of Fed’s ‘Resolve’
Robert Parry, president of the Fed’s San Francisco regional bank, said the discount rate hike was an “indication of the resolve of the Fed to resist inflationary pressures.” Parry, one of 12 regional Fed presidents, added that while the discount rate hike was “part of a gradual tightening process” that began in March, it “continues in the form of this announcement to make it clear to the markets that the Fed is still out ahead of the curve.”
Economists had been generally counting on the Fed to tighten its credit reins soon by quietly pushing up the so-called federal funds rate, which reflects the cost of overnight borrowings between banks. But they were not expecting the Fed to act so boldly by lifting the discount rate.
In New Orleans, where GOP officials are preparing for next week’s convention, the Fed’s action represented an unwanted setback.
Frank J. Fahrenkopf Jr., Republican national chairman, was clearly surprised by the news but said it would have no impact on the election.
“I assume with the economy being as strong as it is, there’s a natural concern that it might fuel inflation,” he said. “And therefore the move would be to try to dampen any possible inflation and keep the economy in as great shape as it is.”
Impact on GOP Convention
But conservative analyst Jude Wanniski acknowledged that the Fed’s action was likely to “take the euphoria out of the Republican convention. What it does is add to the generalized, unwarranted fears (among voters) that things are going to get worse in the economy.”
As recently as Sunday, Treasury Secretary James A. Baker III, who is leaving the Administration later this month to head Bush’s presidential campaign, said he did not expect the Fed to boost interest rates.
“They have not said they’re going to do that,” Baker said. “They have said they want to preserve growth, and they want to guard against inflation. And they’re going to walk the line that’s required to be walked to do that.”
Staff writer Robert Shogan, in New Orleans, contributed to this story.
