Why Fed Is Set To Drop Rates

With the United States banking system starting to show signs of stress, it now appears the Federal Reserve is set to cut interest rates.

When the nation's central bank meets tomorrow, Fed Chairman Alan Greenspan is expected to push for a lower lending rate. If the other Federal Reserve governors agree with Mr. Greenspan, short-term interest rates could drop - with most economists expecting a 1/4-point drop, but some predicting a cut of as much as 1/2 point. This would be the first time the Fed has dropped interest rates since Jan. 31, 1996, when the economy just barely avoided a downturn.

"This rate cut will help to keep the economy strong," says Stan Shipley, an economist at Merrill Lynch & Co. in New York.

If the Fed does drop rates, a main motivation is to help America's banking sector, which is posting loan losses to Russia and Latin America. Only last week, the New York Fed pushed banks and Wall Street firms to provide a $3.5 billion bailout to Long-Term Capital Management LP, a speculative trader of government and international securities.

"What we are seeing are some cracks in the financial institutions. Banks are losing bundles of money," says John Burgess, a managing director for global investing at Bankers Trust Co.

Adds David Lereah, chief economist at the Mortgage Bankers Association, "The Long-Term Capital problem may be enough to scare the presidents of the Reserve banks - and some are opposed to a rate cut - to let Greenspan have his way and cut rates."

There is some opposition in the Fed to a rate cut because the Main Street economy continues to hum along despite pressure from imports and uncertainty in Washington. However, at a Senate hearing last week, Greenspan signaled that the time might be right for a change in monetary policy.

IF the Fed does act to provide banks with lower borrowing costs, it will have a ripple effect on the economy.

* Mortgage rates, at 1960s levels, will remain low and perhaps edge even lower. In the past three weeks, mortgage rates have dropped from above 7 percent to about 6.7 percent for a 30-year fixed-rate loan. On a $100,000 loan, this is $35 a month in savings. Economists expect rates might decline some more if the Fed acts. "I am looking for a little more down but not a heck of a lot," says David Seiders, chief economist for the National Association of Home Builders, a trade organization based in Washington.

* Consumer credit, such as auto loans or installment loans, may become less expensive because they are linked to Treasury bill rates that are short-term. "Depending on the time period, many of them have already declined substantially, but they may go down a little more," says Sung Won Sohn, chief economist at Norwest Corp. in Minneapolis. But he notes that with banks earning less on their Treasury notes, they may have to cut consumer deposit rates for depositers.

* The dollar may weaken because US financial assets are relatively less attractive. A weaker dollar makes US exports more competitive. "It would help West Coast industries, which have been hit hard, and US agriculture," says Veronika White, an economist with First Union Corp. in Philadelphia. Lower interest rates would also benefit countries such as Brazil or Mexico, which tie their rates to US rates. "For a lot of emerging markets, it takes pressure off them," says Mr. Shipley.

* The financial markets may become more confident. In recent weeks, the stock markets have been weak-kneed. Until last Wednesday, for almost three weeks, there were no new stock market Initial Public Offerings, that is, companies issuing stock for the first time. "Companies were losing their ability to get cash from the equities market. The bond market was hostile, and banks were not making new credit available, says Mr. Burgess. "A Fed move would help to provide some psychological calm to markets that are messed up."

A stronger stock market could also help the real estate market. For example, real estate prices in New York have started to fall as Wall Street firms begin to contemplate layoffs. "We are very securities-industry dependent here," says Clark Halstead of Halstead Property Co., one of the city's top real estate sales firms. "So any help we get on the stock market is very useful."

A firmer stock market would help Brooklyn residents Elizabeth Ferber and her husband, Josh Libowitz. They are hoping to sell their co-op to buy a house in the suburbs. "Now people are dropping their asking prices," says Ms. Ferber, a freelance writer. "People feel they don't have a lot of control over interest rates. You just hope that ideally they will be in your favor when you are ready to move."

That was the case for a client of Scott Cohen of the New Rochelle, N.Y., office of Oshlag-Eisner Realty. He recently sold a home in New Rochelle to a woman who spent $50,000 more than she planned to because of the lower rates. "She was more confidant spending the extra money with interest rates this low," says Mr. Cohen.