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Federal Reserve moves to inject fresh incentive into sluggish US economy. Fed drops discount rate half point; two major banks cut prime rate

By David T. CookStaff writer of The Christian Science Monitor / May 20, 1985



Washington

The Federal Reserve Board, concerned about the sluggish pace of the United States economy, is signaling it will support somewhat faster growth by encouraging lower interest rates. That is how analysts read the Fed's announcement late Friday that it is cutting its discount rate half a percentage point to 7.5 percent effective today. The discount rate is the interest district Federal Reserve Banks charge financial institutions for funds they borrow. Last week's move brings the discount rate to its lowest level since August 1978.

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The discount rate move signals a shift to a somewhat more accommodative monetary policy, with the Fed moving to put downward pressure on interest rates, analysts say. Lower rates, in turn, are expected to spur faster economic growth, buoy the stock and bond markets, take some financial pressure off the troubled savings and loan industry, and ease upward pressure on the dollar and thus help US exports.

Analysts caution that these potential effects of Fed policy decisions are felt after a time lag and that consumers should not look for an immediate drop in the loan rates they are charged.

But the Fed's announcement was followed almost immediately by word that two of the nation's largest banks, second-ranked Citibank and third-ranked Chase Manhattan, were trimming their prime rate half a percentage point to 10 percent, effective today. The prime rate is a benchmark rate used for setting charges to other customers.

Banker's Trust Company, the eighth-largest US bank, cut its prime last Wednesday but that move was not followed by other large banks. A widespread adjustment to the 10 percent level is expected today, however. At 10 percent, the prime is at its lowest level in 61/2 years.

The discount rate reduction, which triggered the latest reductions in the prime, is an ``explicit indication'' that the Fed has decided to loosen monetary policy to spur a rebound from recent lackluster growth, says Jerry Jasinowski, senior vice-president and chief economist at the National Association of Manufacturers. With only the residential housing sector of the economy showing strength, the Fed was ``faced with the possibility we could be looking at 2 percent growth for all of 1985.'' Such slow growth would put upward pressure on both unemployment and the federal budget deficit, he notes.

A reduction in the discount rate had been anticipated by credit-market watchers, but they expected the change to come after tomorrow's meeting of the Fed's policy-setting Federal Open Market Committee.

In explaining its decision the Federal Reserve said, ``The action was taken against the background of relatively unchanged output for some time in the industrial sector of the economy, stemming heavily from rising imports and a strong dollar. Price pressures, while clearly a continuing concern in some areas, appear to remain relatively well contained in goods-producing sectors of the economy, and sensitive commodity prices are generally at their lowest levels in about two years.''

Signs of sluggish economic growth were evident last week when the government reported that industrial output dropped in April for the first time in six months while the portion of the nation's manufacturing capacity being used declined half a percentage point to 80.6 percent. Tomorrow the government is slated to release a revised estimate of overall economic growth in the first quarter of 1985.

``I think the number is going to look scary, and the Fed wanted to act before it came out,'' said Kathleen Cooper, an economist at Security Pacific National Bank in Los Angeles.

The combination of sluggish growth and Fed action to ease credit-market conditions ``will keep pressure on rates downward,'' Mr. Jasinowski says. The prime could be ``under additional pressure in the next two quarters,'' he says. While cautioning about the danger of interest rate forecasts, he says the prime could ``drop below double digits.'' However, other analysts note that some market rates already have fallen in antitipation of the Fed's discount rate move.

The Fed acted despite contradictory evidence on the growth of the money supply. Too rapid growth of the money supply can trigger inflationary pressures. One money supply measure, M-1 (private checking deposits and cash), is above the Fed's target range while two others, the broader M-2 and M-3, are within Fed target zones.

The Fed's statement said ``growth of the monetary aggregates has slowed appreciably, although M-1 has remained somewhat above the path implied by the annual target. In this setting a reduction in the discount rate consistent with the declining trend in market interest rates over recent weeks appears appropriate.''

The lower interest rates the Fed is expected to seek through credit-market operations have a variety of positive consequences. They make it easier for consumers and corporations to buy goods on credit, thus spurring economic growth. Higher economic growth tends to boost stock prices. And lower rates tend to raise the prices of existing bonds.

To the extent interest rates fall, the US is a less attractive place for foreign citizens to invest. As a result the demand for dollars goes down and with it the dollar's price on world currency markets. As the dollar falls, it makes it easier for US companies to sell goods overseas.

Finally, lower interest rates boost the value of mortgages held by savings and loans while lowering the rate they have to pay depositors for funds. Privately insured S&Ls in Maryland faced massive withdrawals last week as depositors became concerned about their financial health.