The bank prime rate has come under pressure amid sharply declining interest rates and other omens of possible recession.
The 300-basis-point spread between the prime and federal funds rates has buoyed bank profits for several years. But after a weak May employment report Friday, Southwest Bank of St. Louis broke ranks with other banks. It cut its prime lending rate to 8.5%, from the prevailing 9% level.
With the federal funds rate standing at 6%, if the spread between it and the prime rate were to narrow industrywide, analysts said, it could put further pressure on bank profitability.
Some observers had already questioned how long the record spread between the prime and funds rates could go on without further eroding banks' share of the lending market.
Worry has also surfaced that banks might compensate for their disparity with market rates by accommodating borrowers through loosened underwriting standards.
While Southwest Bank often leads the industry in altering the prime rate, it was atypical for any bank to act without a change first in short- term rates controlled by the Federal Reserve. Citibank, the flagship unit of Citicorp and the nation's largest bank, said it would not follow suit.
The Fed, meanwhile, appeared reluctant to respond to market pressures by reducing the funds rate.
While other interest rates have been falling sharply, the Fed is apparently reluctant to be seen as on the defensive, and it may also be mindful of the impact on the value of the dollar if it cuts rates.
The Fed could ease credit at the July 5-6 meeting in Washington of its policymaking Federal Open Market Committee, or it could wait for further data before acting at the committee's Aug. 22 meeting.
But it cannot wait too long if economic weakness persists, said Mickey Levy, chief economist for NationsBanc Capital Markets, New York, a unit of NationsBank Corp.
In holding the funds rate unchanged at 6%, "the Fed is increasingly tightening credit because bank reserves are declining," he said. "At some point, they will have to address the decline in liquidity."
Market rates plunged again Friday after a far weaker than expected employment report for May capped a string of reports last week of tepid economic activity and signaled strongly that economic growth may be stalled, with a recession ahead.
Indeed, market-based rates have declined so much that yields on most maturities of Treasury security have fallen below the federal funds rate.
"The slope of the yield curve has been an excellent indicator of economic downturns in the past," said Sung Won Sohn, chief economist at Norwest Corp., Minneapolis.
A particularly strong signal was given by the spread between the 10-year government bond yield and the federal funds rate. Friday, the yield on 10- year Treasuries dipped below the 6% rate for overnight borrowings, Mr. Sohn noted.
"This situation has predicted recession every time it has happened, with only one exception, in 1966 during the buildup period of the Vietnam War," he said.
Recessions followed other such inversions of the yield curve in April 1968, February 1973, September 1978, October 1980, and January 1989.
