Downward Trend Seen in Prime Rates

With the fed funds rate clearly cut by 25 basis points Thursday, observers expected banks to reduce their prime lending rates as well.

"I think there is a prime-rate cut in the works," said Gary Ciminero, chief economist of the Fleet/Norstar Financial Group.

The prime-rate easing is generally expected to be a modest one, to 7.75% from 8% - a step that First Fidelity Bank, Lawrenceville, N.J., has already taken.

Foreshadowing Move on Prime?

A cut in the fed funds rate is generally seen as a shot across the bow of the prime lending rate, the benchmark for many commercial and consumer loans.

In recent rounds of prime-rate cuts, banks have waited until the first of the month to move, which lets them leave floating-rate loans pegged to the prime at a higher level for up to a month.

Money-center banks, which normally cut interest rates first, would not comment on their plans.

Still, it was nearly unthinkable that the prime lending rate would remain at 8%, if for no other reason than the political pressure from the White House. President Bush has made clear his determination to end the so-called credit crunch.

Eyes on Discount Rate

Should the Federal Reserve take the added step of reducing the discount rate it charges on bank borrowings, the move would surely trigger cuts in the prime rate. A discount rate cut could occur as early as today, after release of October's employment data.

But in any case, the outcome is far from certain.

Bankers tend to doubt that a lower prime rate would ignite loan demand. Recent evidence supports this view. Banks trimmed their prime rates from 8.5% in mid-September in lockstep with the Fed's announcement of a cut in the discount rate. Yet loan demand remained anemic.

But a prime-rate cut is what the Fed wants, observers said. "The market consensus is that the new fed funds target is 5%," said Robin Corlew, a fed funds trader at First Union Corp.

Fed Funds at 5%

The fed funds adjustment was slight, down 25 basis points to 5%. Many economists had predicted a deeper cut, given the fear that recession could overtake recovery. But the trim is characteristic of the Fed's cut-and-wait progress throughout the year.

Some economist argue that banks may not be so quick to jump in response to a change in the fed funds rate. In their view, the cost of funds has not fallen significantly since the last cut in the prime rate. The cost of funds, which is tied to deposit rates, is a more important measure of banks' intentions than the bank-to-bank fed funds loan rate.

For example, the spread between the prime rate and the 90-day certificate of deposit rate in early September was 220 basis points. Now, it is 208 basis points - not the expected 170 basis points.

Cuts Have Done Little

The Fed has steadily trimmed the fed funds and discount rates in the past 12 months. But the elixir of lower rates has done little to create a sustained recovery.

Gains in employment in October are expected to be minimal, roughly 25,000 people added to payrolls. That would be about the same as in September. In the past six months, only 250,000 jobs have been added in the economy. That many new jobs has been considered a slow month in other recoveries.

The Fed's steady trimming of the fed funds rate, from 8% in 1990 down to nearly 5%, has not affected critical long-term rates, which are pegged to the 30-year Treasury bond. The latter rate is crucial to corporate investment decisions and the mortgage market. The 30-year bonds, for example, still yield more than 8% - barely changed in the past two years.

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