Fed expected to end bias for rate hike.

Federal Reserve policymakers are expected to back away from the current pro-tightening stance in light of the weak employment report released last Friday.

The Federal Open Market Committee, which meets today and tomorrow, is likely to return to a neutral stance on monetary policy, favoring neither a tightening nor an easing.

"The last thing we would want to do now is even talk about raising interest rates," said Sung Won Sohn, chief economist at Norwest Corp.

And the following FOMC meeting, on Aug. 17, may result in another switch, this time to a pro-easing bias.

"If the economic data between now and then show the economy as soft as the data of recent weeks, the FOMC will vote to favor an easing," said Eugene Sherman, economist for M.A. Schapiro & Co.

"Right now, we are more likely to see a Fed easing than a Fed tightening," said Moody's Investors Service economist John Lonski.

For Appearances' Sake

Gary Schlossberg, economist at Wells Fargo & Co., is less sure of a change in policy.

"The Fed may not want to appear to be flip-flopping, and it may make more political sense to keep the bias but still not do anything," he said.

The discount rate and the target for the federal funds rate are both now 3%.

Under the current pro-tightening stance, Federal Reserve Chairman Alan Greenspan has authority to nudge the target for the federal funds rate a half point higher.

A Complete Turnaround

A change to neutral would mean Mr. Greenspan could not ease or tighten without a telephone conference with other committee members.

Talk of lower rates marks a complete turnaround in psychology from just six weeks ago, when the committee adopted the pro-tightening bias amid fears that inflation was about to explode.

But inflation fears - still alive because of increases in the prices of gold and other commodities - have become subordinate to worries about stumbling economic growth.

The Labor Department said Friday that payrolls expanded a meager 13,000 in June - about one-tenth the level of economists' expectations. Employment grew by 209,000 in May. The unemployment rate rose in June by 0.1 percentage point to 7.0%.

This came on top of earlier reports late last month showing weakness in housing, durable goods orders, and manufacturing activity.

"The economy is just barely holding its nose above water," said Lacy H. Hunt, chief economist for Carroll McEntee & McGinley Inc., a unit of HSBC Holdings. "The Fed badly misread the economy."

The Fed and some economists may have been caught off guard by the sharp reaction from small business to President Clinton's deficit-reduction plan and the prospect of health-care reform. With higher taxes and a possible outlay to cover health costs hanging over their heads, many small businesses are unwilling to add jobs, economists said.

The grim economic news of recent weeks will mean lower interest rates, economists said.

Mr. Lonski expects the yield on the 30-year Treasury bond to fall below 6.60% and that on the 10-year note to fall below 5.70% by the summer's end. Mr. Hunt sees the long bond at 6.50% or lower by summer's end.

On Friday, the 30-year Treasury yielded 6.67%, equaling the record closing low. The 10-year note yielded 5.75%. Assuming short-term rates stay the same or are nudged lower, banks will wish this summer were endless.

Low short-term rates mean a continuation of cheap deposit funding. Falling longer-term rates mean capital gains on banks' securities holdings and inexpensive funding on the capital markets.

Since banks are not expected to cut the prime from the current 6% even if the Fed eases, net interest margins should stay fat.

Even with low rates, loan demand will continue to be weak if the economy sputters.

For reprint and licensing requests for this article, click here.
MORE FROM AMERICAN BANKER