In its most aggressive move yet to ease credit and stimulate a faltering economy, the Federal Reserve Board cut its key lending rate Tuesday for the first time in four years, reducing it by half of a percentage point to 6.5%.
The Fed’s decision to use its most potent weapon in the fight to stave off a severe recession came amid signs that the economy is rapidly weakening and that the threat posed by inflation, which had inhibited the Fed from acting dramatically before, is moderating.
Tuesday’s action was designed to encourage business activity by nudging banks toward reducing their prime rates for their best customers. A drop in the prime rate eventually would be expected to lead to lower borrowing costs for all customers.
The cut in the discount rate--the interest the Fed charges on its loans to commercial banks--came as the government reported that consumer prices rose just 0.3% in November, the smallest increase since the Persian Gulf crisis began driving up oil prices in August.
The Labor Department’s consumer price report suggested that the surge in oil prices has not caused a worsening of inflation in the rest of the economy. The modest November increase followed three months of much higher inflation: 0.8% in August and again in September, and 0.6% in October. Most of the earlier gains were attributable to soaring energy prices.
While energy prices rose 0.5% and food prices rose 0.4% during November, consumer prices actually declined in other sectors.
In the Los Angeles-Anaheim-Long Beach metropolitan area, consumer prices rose a scant 0.1% in November, before being adjusted for seasonal factors, well below the 0.9% surge posted in the region in October.
In a separate report, the Commerce Department said the surging cost of imported oil, combined with an unexpected increase in imports of capital goods and automobiles, pushed the merchandise trade deficit to $11.6 billion in October. The monthly deficit was the biggest since February, 1988, and was considerably above expectations.
Both the trade and consumer price reports confirmed the widely held view among economists that the nation has entered a recession, and that the economy may be in for a worse slump than previously anticipated.
“All the information that is coming out on the economy these days is bad news,” said Kirk Carl, a senior economist at the WEFA Group, an economic forecasting firm in Bala Cynwyd, Pa.
“The fourth quarter looks a lot worse than we had expected,” added David Wyss, an economic forecaster for Data Resources Inc. in Lexington, Mass.
Economists said they believe that the worsening outlook gave Fed Chairman Alan Greenspan the breathing room he needed to cut interest rates without fearing that easier credit would cause a renewed burst of inflation.
“I think Greenspan is thinking that inflation is less of a problem than it looked like a couple of months ago, and that the threat of recession is more of a problem than it was,” said Robert Hormats, vice chairman of Goldman, Sachs & Co. in New York.
Wall Street sent a strong signal that it believes the Fed’s action was prudent; the stock market soared Tuesday afternoon on late news of the discount rate reduction. The Dow Jones average of 30 industrial stocks jumped 33.41 points, to close at 2,626.73.
“This rate cut came sooner than I expected, but the markets are reacting very positively, and they don’t seem to sense any inflation problems,” noted Lawrence A. Kudlow, chief economist at the New York investment firm of Bear, Stearns & Co.
The White House, which has been lobbying Greenspan heavily in recent months to reduce interest rates, hailed the central bank’s move. Michael J. Boskin, President Bush’s chief economic adviser, said that the drop in the discount rate was “very sensible.”
Cutting the discount rate is the third tool used by the Fed in recent months in its battle against an economic slowdown. The central bank already has cut the federal funds rate--the interest banks charge each other for overnight loans--three times in the last few weeks. Earlier this month, the Fed eased its requirements involving the financial reserves that banks must maintain to back up certain types of large deposits, a move that infused the banking system with cash and helped ease a worsening credit crunch.
But economists said the decision to cut the discount rate for the first time since 1986--and to do so by a surprisingly hefty half of a percentage point--was by far the most dramatic action taken by the Fed. Economists said that the move signaled the seriousness with which the central bank now views the potential for a severe downturn.
“This was a clear sign from the Fed that they are concerned, and that they are going to continue to loosen up on interest rates to avoid a severe recession,” Wyss said.
The Fed’s action should prompt major banks to reduce the rates they charge corporate and individual borrowers for a wide array of loans, economists said. But some banks, under pressure from federal regulators to increase profitability to avert a banking crisis and replenish the federal deposit insurance fund, may be reluctant to cut rates quickly.
While many banks may reduce the prime rate they charge their best corporate borrowers, other rate reductions may come more gradually, as banks seek to keep a wide “spread” between the rate they pay to borrow from the Fed and the rates they charge their customers.
“I would expect banks to move on the prime rate, but I think they will hold on as long as possible before they do that,” Hormats said. “So, I don’t think this discount rate cut will translate immediately into much lower borrowing costs for most people.”
But further rate reductions by the Fed over the next few months are widely expected, as more evidence of a recession is reported. Many economists believe that the Fed will cut the discount rate at least once more in early 1991 and is likely to reduce the federal funds rate two or three more times before the recession is over.