Fed Eases Credit a Notch; Small Bank Cuts Prime : Board Committee’s Policy Shifts From Cooling Inflation to Preventing Recession

The Federal Reserve allowed a key interest rate to fall slightly on Friday, a signal that it has eased credit another notch, government officials and private analysts said.

The central bank, which had been taking steps to hold the federal funds rate at about 9.5% for the past month, left it trading at 9.25% on Friday rather than draining significant amounts of cash from the banking system to keep interest rates up. By the end of the day, the federal funds rate had dipped further--to 9.125%.

Meanwhile, Southwest Bank of St. Louis lowered its prime lending rate Friday to 10.5% from 11%. The bank is often a bellwether for major money center banks, and several economists suggested that the big banks are likely to make similar cuts in their own prime rates on Monday. Many small business and consumer loans, particularly the increasingly popular home equity loans, are tied to the prime.

The Fed began relaxing its grip on credit generally last month, reversing a 16-month-long policy of pushing interest rates higher as part of its effort to fight inflation. That turnaround followed a sharp internal debate among Fed policy-makers, with some officials arguing that interest rates needed to fall to help avoid a recession and others contending that the Fed should not retreat because of the threat of higher inflation.

The Fed’s move followed a two-day meeting of its policy-making Open Market Committee on Wednesday and Thursday. Although the federal funds rate had drifted down to 9.375% late Thursday on financial market speculation that the Fed had decided to ease credit, analysts said it was not clear until the Fed’s action Friday that it wanted interest rates to fall.

“It is now clear the Fed has taken another one-quarter-point easing move,” said Kathleen Cooper, chief economist at Security Pacific National Bank in Los Angeles. “And I wouldn’t be surprised to see it go the rest of the way to 9% if the inflation figures next week look good.”

Signs of Softening

The Fed conducts monetary policy on a day-to-day basis, mainly by actions that change the federal funds rate, the interest that banks charge each other on overnight loans. Infrequently, the central bank also signals its intentions by announcing an increase or decrease in the discount rate, a special borrowing rate used by financial institutions. The Fed’s discount rate is currently 7%.

The Fed’s modest easing followed Friday’s employment report, which provided further evidence of a soft--but still growing--economy and relatively modest inflation pressures. Fed officials, as is their policy, did not comment on the central bank’s money market actions.

Interest rates fell across the board and the stock market rose sharply in response to the Fed’s latest credit-easing move, which was widely anticipated because of recent signs of economic weakness.

But financial markets currently reflect an expectation that interest rates will decline sharply over the next few months, and several analysts warned that investors may be disappointed if the Fed continues to move cautiously in easing its credit grip.

“The markets have gotten too far ahead of the Fed,” said David Hale, chief economist at Kemper Financial Services in Chicago. Fed Chairman Alan Greenspan, Hale added, “is pursuing a policy of gradualism, and I don’t think he is going to ease as much as the markets expect.”

Adding to that caution was the Fed’s release Friday of the minutes from its May 16 Open Market Committee meeting, which disclosed that several members of the 12-member panel still favored continuing the Fed’s policy of tilting toward tighter money.

One Member Dissented

At that meeting, the Fed agreed to move toward a stance “that would make an easing or a tightening of policy equally likely, depending on economic and financial developments and the behavior of the monetary aggregates.”

There was only one dissenter to the decision, St. Louis Federal Reserve Bank President Thomas C. Melzer, who favored an easier credit stance because he was worried that slow growth in the money supply was raising the risk of recession.

While most Fed members have tended to play down the importance of money supply figures in recent years because they have been an unreliable guide to economic activity during the 1980s, the minutes disclosed that other policy-makers were also beginning to worry about sluggish growth in the money supply.

“Members attached considerable importance to the need for an upturn in monetary growth,” the minutes read. “A failure of monetary growth to revive during this period might well signal some further weakening in the business expansion and warrant a special consultation of the committee.”

Greenspan conducted an informal telephone conference in late May, officials say, in which committee members agreed to allow the Fed chairman to ease credit in response to signs of economic weakness.

At the May meeting, the Fed also authorized its New York bank, which conducts currency transactions, to buy more foreign currencies as part of the government’s attempts to keep the dollar from rising. The Fed boosted the limit on foreign currency holdings from $12 billion to $15 billion at the meeting and was forced to raise the ceiling again on June 14 to $18 billion.