Interest Rates May Be Cut, Fed Chief Signals

Federal Reserve Board Chairman Alan Greenspan signaled Thursday that the Fed may ease short-term interest rates to offset tightening of credit by commercial banks.

The highly unusual indication of future Fed policy set off a strong rally in bond and stock prices on Wall Street, with the Dow Jones industrial average rising 37.13 points to a record high of 2,969.80.

Greenspan’s comments were interpreted by some observers as an early answer to President Bush’s oft-voiced prayer for lower interest rates in return for progress on a budget deficit reduction package that would include higher tax revenues.

Greenspan’s response to queries at a Senate Banking, Housing and Urban Affairs Committee hearing was his first acknowledgement that complaints about a tightening of credit have some validity.

Business owners have been saying since last winter that banks have tightened lending standards in response to the savings and loan crisis, a softer economy and weakening real estate markets. Only three weeks ago, Greenspan dismissed those complaints as groundless.

But he conceded Thursday that commercial loan interest rates appear to be rising even though the federal funds interest rate has held steady at about 8.25% since the beginning of the year. That is the rate that banks charge one another for overnight loans. It is a key indicator of Federal Reserve Board efforts to influence interest rates.

Continued market rate increases would be considered “undesirable,” he said, and would justify a relaxed monetary policy.

“The cumulating evidence indicates commercial bank loan rates and collateral requirements are firming in the context of an unchanged federal funds rate,” Greenspan said in a statement prepared in advance of the hearing, apparently in anticipation of a question on interest rate policy.

“If so, that could have undesirable effects on the economy that the Federal Reserve would have to consider offsetting with an ease in monetary policy,” he said.

Greenspan said that Fed officials “are monitoring this situation on a day-by-day basis.”

As Greenspan spoke to the Senate panel, Congress’ chief economist was assuring the Joint Economic Committee that a budget deficit reduction package of as much as $50 billion would not necessarily hurt the economy.

Robert D. Reischauer, director of the Congressional Budget Office, said that the economy would not suffer as long as any deficit deal covers more than one year, is considered credible in financial markets and is accompanied by an easing of monetary policy by the Fed.

Reischauer acknowledged fears expressed by many economists that the $50-billion deficit reduction under negotiation by White House and congressional negotiators could tip an economy growing at an anemic 2% or less a year into recession.

But he said that a strong show of fiscal discipline would encourage the markets and, especially if further rewarded by the Fed, reduce interest rates enough to stimulate economic activity, lower capital costs, expand investment and spur additional export gains.

In fact, the Congressional Budget Office’s updated forecast for the economy estimates growth, inflation, employment and interest rates at levels unusually close to those projected last month by the President’s Council of Economic Advisers.

The CBO estimates show economic growth rising from 2% in 1990 to 2.5% in 1991, inflation remaining moderate at 4.1%, unemployment holding steady at 5.3% to 5.4% and short-term interest rates declining from 7.6% now to just under 7% in 1991.

With the CBO and the Administration making virtually the same economic assumptions, the work of the budget negotiators should be easier, Reischauer said.

He warned, however, that the deficit deal needs to be worked out as a formal legislative package by the time Congress adjourns in October so “businesses can plan ahead, tax policy will be set and the Fed can ease.”

When asked whether the Fed should accede to Bush Administration appeals to ease interest rates in advance of a final deficit-cutting package, Reischauer demurred. That, he cautioned, “would be giving the child his dessert before he’s eaten his broccoli.”

The Administration seems to have stepped up its pressure on the Fed in recent weeks. Treasury Secretary Nicholas F. Brady pointedly criticized the Fed’s interest rate policy a few days before the central bank’s midyear policy review on July 2 and 3, and Bush mentioned the subject as recently as Wednesday in a news conference after the economic summit meeting of industrial democracies in Houston.

However, Greenspan took pains Thursday to explain that any shift toward easing interest rates merely would correct what he regarded as excessive tightening in the market.

“We have been closely watching various interest rate spreads and other indicators to determine if the pulling back of commercial banks to less lax lending standards is moving over the line and in effect creating a tightening in credit markets,” Greenspan said.

Staff writer William J. Eaton contributed to this story.