Senate Banking Committee Chairman Alfonse M. D'Amato called for legislation Wednesday to let the central bank pay interest on reserve balances.

It is the banks' money, the New York Republican said, "and we should let them earn interest on it. I would ask some of my colleagues to consider joining in a legislative effort to do just that."

Sen. D'Amato said he is concerned that dwindling reserve balances-down 34% in a year, to $11.7 billion in January-would impede the Federal Reserve's conduct of monetary policy.

Fed Chairman Alan Greenspan, who was on Capitol Hill to present his semiannual report on the economy, said the central bank has always supported paying interest on reserves. "The problem is that would induce a fairly significant reduction in federal budget receipts," he cautioned.

Mr. Greenspan's comments came amid a discussion focused heavily on the economy. The central bank, he said, is on "heightened alert" for signs of inflation.

"We cannot rule out a situation in which a preemptive policy tightening may become appropriate before any sign of actual higher inflation becomes evident," he said.

The markets reacted to this threat of higher interest rates by pushing up the yield on the 30-year Treasury bond to 6.75% by midday, prompting a substantial selloff in bank stocks. Money-center banks were hit hardest; the S&P bank index fell 1.83% by 1 p.m. and ended the day down 1.46%, at 529.65. The Dow Jones industrial average fell 0.78%, to 6,983.18.

Shares of Citicorp fell $2.125, to $121.625; Chase Manhattan Corp. dropped $2.25, to $103.50; and Wells Fargo & Co. lost $2.25, to $313.75.

Bank economists are predicting a rate hike in the third quarter.

"He is setting the stage for an adjustment later in the year," said Anthony Chan, chief economist for Banc One Investment Advisors Corp.

Mr. Greenspan also said he is worried that financial markets are "overestimating returns" and "mispricing risks." For example, he said, banks are easing terms and standards on business loans, though margins are "razor thin."

He also played down the potential effect of rising consumer credit problems on the economy, noting that banks are pulling back from some of their aggressive credit card marketing practices.

"This is not a major factor in the economy," he said. "It is not threatening to have a significant effect on banks or the financial system."

Mr. Greenspan predicted that inflation would hover at 2.75% to 3% and unemployment at 5.25% to 5.5% during 1997.

But the Fed chairman reiterated his warning about the stock market. "When unwarranted expectations ultimately are not realized, the unwinding of these financial excesses can act to amplify a downturn in economic activity," he said.

"There is no evidence the business cycle has been repealed," Mr. Greenspan said. "Another recession will doubtless occur some day owing to circumstances that could not be, or at least were not, perceived by policymakers and financial market participants alike."

Banks are avoiding the Fed's 10% reserve requirement by sweeping checking account deposits into money market funds, which are not covered by the reserve rule. The Fed, twice last year, warned that reserves were falling too far. Interest payments could cost the Treasury $500 million a year, however, economists have estimated.

While Mr. Greenspan supported Sen. D'Amato's plan for authorizing interest payments on bank reserves, he minimized the effect of dwindling reserves deposited at the Fed.

"We have not experienced any specific problem in implementing monetary policy," he said. "This is truly a technical problem."

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