Fed Boosts Discount Rate to 7% to Battle Inflation
The Federal Reserve Board, signaling its determination to curb inflation even at the expense of economic growth, increased the interest rate it charges commercial banks from 6.5% to 7%.
Shortly before the stock market opened Friday, the Fed announced that it had raised the discount rate to 7% from 6.5%, effective immediately, “in light of the inflationary pressures in the economy.”
“In taking the action, the board voted on requests submitted by the board of directors of the Federal Reserve Banks of Boston, Cleveland, New York, Philadelphia, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City and San Francisco,” the announcement said. Dallas was the last regional bank to request the increase, which will take effect there Monday.
The board voted 6 to 1 for the increase, with only Martha Seger voting against the increase.
The news was a shock for the Bush Administration--which is pinning its hopes for shrinking the budget deficit on robust economic growth--and for financial markets, where stock prices and the dollar were falling.
Prices were sharply lower Friday at the close of the New York Stock Exchange in moderate trading. The Dow Jones industrial average, which rose 5.53 Thursday, plunged 43.92 to 2245.54.
“People are reluctant to make a move over the short run,” said Eugene Peroni Jr., an analyst at Janney Montgomery Scott Inc. in Philadelphia. “We probably won’t see the market go higher for some time.”
The dollar, contrary to expectations, fell after the discount rate announcement. Higher interest rates usually mean dollar-denominated assets are more desirable, sending the value of the dollar higher.
“The long-awaited discount rate hike gave the dollar no upside momentum whatsoever,” said Earl Johnson, a vice president at Harris Trust & Savings Bank in Chicago.
“The market had discounted the rate hike, and some people were disappointed that the increase was not a full percent,” Johnson said. “In addition, there is speculation that the West Germans might raise their own rates next week.”
In late New York trading, the dollar was quoted at 1.8185 against the West German mark, down from 1.8220 late Thursday. Against the yen, the dollar ended the week at 126.10, down from 126.35.
Hugh Johnson, an analyst at First Albany Corp., said he expected the financial markets would respond moderately to the increase because it had been so widely anticipated.
‘It’s a Laggard’
“It’s a laggard,” he said, following a series of gradual increases in short-term interest rates that began last spring.
“In this case, the Fed really just seems to be bringing it into a rational alignment with other short-term interest rates,” he said.
The discount rate is the interest rate the Fed charges depository institutions when they borrow from their district Federal Reserve Banks.
White House budget chief Richard G. Darman minimized the significance of the discount rate increase, saying it increases in other interest rates.
“The discount rate tends to follow, not lead,” he told reporters.
‘Prod for Action’
“Whatever one thinks of that, it should be an additional prod for action once we are in negotiations” with Congress on a plan to cut the massive U.S. budget deficit.
Darman, unlike President Bush or Treasury Secretary Nicholas F. Brady, refused to criticize the Fed directly for pushing up rates, even though it severely damages prospects for Bush’s plan to balance the budget without new taxes.
“I hope I’m able to resist at all times the temptation to get into commenting on the wisdom of what the Fed is doing,” Darman said.
The increase comes as Bush was making a high-profile trip to Asia to attend the funeral of Japanese Emperor Hirohito, along with the heads of state of dozens of other countries.
Sign of Seriousness
Allen Sinai, chief economist for the Boston Co., said most other countries should welcome the news as an indication the United States is serious about controlling inflation.
“Most of the world will applaud the Federal Reserve for standing against inflation and wonder whether it’s been too little too late,” Sinai said.
Others may not be delighted.
“I do not know if it would be that warmly received by other countries,” Hugh Johnson said. “It implies the dollar should be strengthened and their currencies weakened.”
Raised in 1988
The discount rate has been 6.5% since Aug. 9, 1988.
The Federal Reserve Board then defied political considerations and raised its benchmark discount interest rate less than one week before the opening of the Republican National Convention in New Orleans.
The news sent the value of the dollar soaring and raised fears that the trade deficit would suffer because U.S. goods would lose the competitive edge in world markets that they gained with the falling dollar.
‘Countdown’ to Crash
The Fed had kept the interest rate at 6% from Sept. 11, 1987, when the board, in agreement with Alan Greenspan, the new chairman, raised the discount rate from 5 1/2%.
Critics at the time “accused him of starting the countdown to the stock market crash” of Oct. 19, 1987, said David Jones, senior economist at Aubrey G. Lanston Co., a New York securities firm.
The last time the discount rate topped 6.5% was in March, 1986, when the Fed set a 7% rate, as interest rates continued a five-year tumble from the double-digit levels of the early ‘80s. The discount rate peaked at 14% in early 1981.
