Fed’s Action on Reserves Signals an Easing of Credit

The Federal Reserve sent a signal Wednesday that it was nudging interest rates lower, and U.S. commercial banks were expected by economists to lower their prime lending rates soon.

Economists said the action by the Fed to add reserves to the banking system was a clear move to ease credit. They said banks would lower their prime rate to 10% from 10.5% soon, probably before the end of the year.

The Fed’s action was widely expected by the financial markets and the White House following fresh signs of economic weakness, particularly in real estate and manufacturing.

The addition of reserves by the Fed pointed to an easing of a key money market rate, the federal funds rate, to 8.25% from a recent average of 8.5%.

“With the Fed indicating unambiguously an ease to 8.25% (in the federal funds rate), I would expect a 10% prime rate by the end of the year,” said David Jones, chief economist of Aubrey G. Lanston & Co.

A cut to 10% in the prime would bring the key rate to its lowest level since August, 1988.

The last reduction in the prime--the rate at which banks charge small and medium-sized business for loans--came in June, when it was lowered from 11%.

The spread between the prime and rates on certificates of deposit also suggests a prime rate cut, said Michael Moran, chief economist of Daiwa Securities America Inc.

“Typically, when the spread between the prime rate and CDs is 200 basis points (two percentage points) or more, you see a cut in the prime. By late November and early December, we were already there. Now, with the Fed reducing interest rates, the chance is good for a prime cut,” Moran said.

Economists said the Fed’s action was significant because it occurred when federal funds were 8.44%, below the perceived Fed target zone of 8.5%.

“This was an unambiguous sign from the Fed. They’re not making any mistakes this time,” Gallagher said.

Last month, the markets incorrectly interpreted a Fed open-market operation as a sign of easier credit.

The Fed’s latest easing came a day after the Fed’s Open Market Committee, its policy-making arm, concluded two days of meetings to discuss the state of the economy.

Soft U.S. economic data have given the U.S. central bank ample reason to ease, analysts say.

Although interest rates have been kept firm to fight inflation, figures released Tuesday showed consumer prices rose 0.4% in November after rising 0.5% in October, posing no immediate price threat.

White House spokesman Marlin Fitzwater said Tuesday that the “continued decline in inflation holds some promise for lower interest rates.”

The Senate Banking Committee’s annual report on monetary policy, released Wednesday, said the Fed appears willing to modestly increase the risk of a recession to curb inflation.

“That does not appear to be an unreasonable approach,” the report said. However, the committee added that it assumed the Fed would respond quickly to signs that the economy was slipping into a recession.

The report was based on testimony by Federal Reserve Board Chairman Alan Greenspan in February and August.

The Fed last eased in early November, soon after the October employment data. The markets thought the Fed had eased again when reserves were added just prior to Thanksgiving. But the Fed then drained soon after, sending the markets reeling.

However, there was little doubt in analysts’ minds as to the Fed’s intentions Wednesday.

“Overnight system repurchases with funds edging downward are as clear a signal as could be,” said senior vice president Joseph Plocek at McCarthy Crisanti and Maffei.