Fed Plays Santa, Trims Key Rate Financial Markets Welcome Unexpected Decision

The Federal Reserve Tuesday gave the U.S. economy a surprise Christmas gift - a small cut in short-term interest rates.

The central bank reduced the federal funds rate - the rate banks charge each other on overnight loans - from 5.75 percent to 5.50 percent. Many economists had predicted the Fed would take no action on rates without some resolution of the budget debate in Washington.

“The Fed made the decision on the economic fundamentals,” said Wayne Ayers, chief economist at the Bank of Boston. Those fundamentals include a sluggish economy and very modest inflation.

Financial markets, which slumped badly Monday on fears the Fed would do nothing, rallied Tuesday afternoon. The yield on the 30-year Treasury bond dropped from 6.20 percent to 6.10 percent. The Dow Jones Industrial Average climbed 34.68 to close at 5,109.89. Monday the Dow lost 101 points, its biggest one-day drop in four years.

“This is important for financial markets, but what does it mean for real people? Not much,” said Nicholas Perna, chief economist at Fleet Financial Group. Perna said if major banks cut their prime interest rates, consumers would see a small decline in borrowing costs on credit cards and home equity loans. Mortgage rates are not directly influenced by Fed actions.

Late Tuesday, Banc One, a major national bank based in Ohio, cut its prime lending rate from 8.75 percent to 8.50 percent. Other big banks were expected to follow. The prime is the rate at which banks make loans to their best customers. Certain consumer loans are tied directly to the prime.

Tuesday’s tiny drop in rates is not expected to provide much of a lift to the economy. Many forecasters expect the Fed to cut rates further in early 1996 if the economy shows signs of weakness.

In its usual cryptic fashion, the Fed’s policy-making body, the Federal Open Market Committee, said very little to explain its decision. “Inflation has been somewhat more favorable than anticipated and this result, along with an associated moderation in inflation expectations, warrants a modest easing in monetary conditions,” said Fed Chairman Alan Greenspan in a brief statement.

Inflation has not been a threat in 1995. Prices this year are expected to rise about the same 2.7 percent they rose in 1994. Wage increases are equally small.

But low inflation alone does not explain the Fed action said David Wyss, senior economist at DRI/ McGraw-Hill in Lexington. “We need a little Christmas,” said Wyss. Consumers have kept their wallets in their pockets this shopping season. Car sales have also been disappointing. And American factories have signaled they have built up too much inventory, suggesting tough times in the months ahead.

While almost no one is predicting a recession, many forecasters think the economy will be hard-pressed to gain much momentum in 1996. The Fed has said it considers 2.5 percent growth the ideal pace for the economy. If growth starts to sag below that pace, the central bank could cut rates several times next year, predicted Ayers. “I think they want to make sure the soft landing doesn’t get too soft,” he said.

The wild card in Tuesday’s decision was Washington. Greenspan has said repeatedly that he would like to see the federal budget deficit eliminated, and he has hinted that such action would make it easier for the Fed to cut rates. As a huge borrower, the federal government puts upward pressure on rates, say analysts. Lower interest rates have been a major prop beneath this year’s remarkable stock market rally.

Several weeks ago, it looked as if President Clinton and the Republican Congress were moving toward a deal on the budget. Since then, progress has stalled and parts of the government have been shut down for the second time. On Wall Street, there was a fear that the central bank would not want to reward Washington for a job badly done.

Instead, said economists, the Fed basically ignored the squabbling in Washington.