Experts: Fed Should Ease - But Probably Won't

The Federal Reserve has room to cut interest rates another notch this month, economists say. Whether it will do so is another question.

"There is room because the inflation situation is so good, but I doubt they will," said Allen Sinai, chief global economist at Lehman Brothers. "The Fed is focused on economic growth, and to go down another notch at their next meeting on Aug. 22 would require some very weak business reports."

After raising rates to restrain strong growth last year that it felt might stir up inflation, the central bank changed course last month and eased credit slightly.

Since then, mixed data have seemed to show that the economy is neither headed toward recession nor rebounding strongly.

That is close to the "soft landing" the Fed hoped to engineer through its monetary restraint before July 6, when the federal funds target rate was cut to 5.75% from 6%.

On the other hand, "real" interest rates remain steep after adjusting for inflation.

Financial consultant Bert Ely noted that the fed funds target rate, the overnight interbank lending rate controlled directly by the Fed, remains atypically higher than the three-month Treasury bill rate.

In fact, the bill rate has remained in roughly the same range since several weeks before the Fed eased. Treasury market players had apparently been anticipating a half-point cut in the funds rate, not a quarter point.

The disparity in the two rates suggests that the federal funds rate "needs to be cut by at least another 25 basis points," Mr. Ely said, in order to maintain its relationship "with real world interest rates, specifically the three-month Treasury bill rate."

The fed funds rate is customarily near the bill rate, he said, and slightly below one-month and three-month private-sector rates.

Those private-sector rates have actually tracked the Fed more closely than the bill rate. As of Friday, Mr. Ely noted, one-month rates for commercial paper, finance paper placed directly, certificates of deposit, and Eurodollar deposits averaged 5.79%, having fallen from 5.99% just before the Fed acted.

Meanwhile, three-month rates for these four types of securities plus bankers acceptances, had slipped to 5.73% by Friday from 5.83% on July 5.

Lehman's Mr. Sinai said the Fed "has nothing to lose by waiting until its Sept. 26 meeting, at which time they will have a good fix on the third- quarter economy."

But he noted that the inflation-adjusted funds rate is lofty in view of tame inflation. "Ultimately, the funds rate will have to come down further to keep the economy in the 2% to 3% growth range," he said.

Mr. Sinai thinks inflation will run about 2.75% this year, meaning the "real" funds rate would be 3%, or about one percentage point higher than its historical average.

Still, he cautioned that no one knows what funds rate is best for running the economy at the 2.5% annual growth rate the Fed thinks is optimal. "In a sense, the Fed is experimenting," he said.

Robert G. Dederick, economic consultant to Chicago's Northern Trust Co. said, "The data certainly offer room for the Fed to move down, and I don't think anyone would be deeply upset if they did.

"The economy isn't falling apart, but rates are sort of high, so a move could certainly be justified," he said. Nevertheless, Mr. Dederick thinks the Fed will wait the rest of the summer, collect more data, and act in September.

Mickey D. Levy, chief financial economist at NationsBanc Capital Markets Inc., a subsidiary of NationsBank Corp., is certain the central bank now has ample space for further rate reductions.

"Quite simply, the real economy is growing moderately while inflation is peaking out for this (business) cycle and will be coming down for the next couple of years. The Fed definitely has room," he said.

"Inflation fundamentals keep on improving," Mr. Levy said. "And so we have a 'real' funds rate that keeps on rising as inflation comes down."

The impact of the Fed's credit tightening campaign prior to July is unfolding in three stages, he said.

The initial impact was on the financial markets last year, he said. This year, the growth rate of the economy has been dampened.

Finally, it affects inflation, as we are now beginning to see, he said. "The outlook for 1996 and 1997 is steadily improving," he said. "The inflation pipeline now seems more empty than full."

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