Greenspan steps up his fight against inflation. Hike in discount rate is out of character for Fed in election year
The financial markets regarded the Federal Reserve Board's decision Tuesday to boost the discount rate as both a bold and somewhat surprising move against an acceleration of inflation. The decision was notably courageous in its timing, coming a week before the Republican convention. The Fed usually lies low in a political year for fear of appearing partisan.
``It is a gutsy move,'' says Dr. Lacy H. Hunt, an economist with Carroll McEntee & McGinley, a bond dealer. Federal Reserve chairman Alan Greenspan ``has definitely helped establish his credibility as an inflation fighter,'' he says.
The boost in the discount rate, the interest the Fed charges on loans to commercial banks, from 6 to 6.5 percent was unexpected as it happened only hours before the Treasury began a three-day auction of $22.9 billion in government notes, bonds, and cash management bills.
The decision will be expensive for the Treasury, notes David Wyss, an economist with Data Resources Inc., an economic consulting firm based in Lexington, Mass. The Treasury will have to pay a higher interest rate on its borrowing than it might have if the Fed had waited until Friday when the auction is past.
``It suggests some desperation,'' adds Mr. Wyss.
But seeing a huge gap between higher short-term interest rates in the market and the discount rate charged by the Fed, financial analysts have been expecting the Fed to boost the discount rate. The rate now stands at the highest in more than two years.
From the standpoint of the consumer, the Fed's decision could be expensive.
Economists suspect commercial banks will hike their prime rate charged better customers from 9.5 percent to 10 percent before the GOP convention next week.
``They [bankers] will rely on the convention to hide the political fallout,'' Wyss says.
The charges on some $800 billion in mortgage loans vary according to prevailing interest rates. For most of these loans, a change in the interest rates takes several months or a year or two to occur. But for those with outstanding home-equity loans, which now exceed $40 billion, the financial impact will occur within a month. These homeowners will be paying an extra $200 million a year as a result of a 0.5 percent increase in the prime rate. Interest rates on automobile loans could also increase.
These extra charges should slow the pace of the economy, perhaps late this year or in 1989, which is just what the Fed wants.
Michael Keran, chief economist for the Prudential Insurance Company of America, sees a greater risk of an actual recession next year. ``The Fed is following conservative [economic] policies,'' he says.
But most economists have been anticipating continued strong growth. The consensus of the panel of 51 economists surveyed by Blue Chip Economic Indicators earlier this month finds them marking up their average forecast for economic growth at 3.8 percent this year (up 0.4 percent from the July survey) and to 2.3 percent next year (up 0.1 percent).
If the economy does slow to a 2 to 2.5 percent range, Fed officials would consider that change highly desirable. They have been concerned with various signs that the economy is being stretched too far, possibly boosting inflation. The news of the hiked discount rate prompted a fall in stock prices. It also boosted the US dollar on the foreign exchange markets, something the Fed does not want as it could discourage exports.
``They [Fed officials] were in kind of a bind,'' says economist Michael Andrews. ``They had a choice between slowing the economy and ignoring that and keeping a lid on the dollar.''