The Federal Reserve tightened credit for the first time in more than two years Tuesday, laying the groundwork for banks to raise lending rates in coming days.
The Fed raised the federal funds target rate 25 basis points to 5.5%. The move could mean tighter profit margins for banks and, ultimately, a drop in loan demand.
Although Fed Chairman Alan Greenspan had signaled the increase in a series of public statements, the announcement seemed to throw cold water on a rally in bank shares that had started Monday morning.
By day's end Tuesday the Standard & Poor's bank index was at 516.90, off 1.01% for the day.
The Fed, which left the discount rate unchanged at 5%, said it was necessary to tighten rates "slightly" to ward off inflation that could result from "persisting strength in demand" in recent economic reports.
The Fed controls credit by tinkering with the federal funds rate, charged on overnight loans between banks, and the discount rate, which the Fed charges member banks for loans. The central bank's last change to the federal funds rate was a 50-basis-point easing in the first quarter of 1996. It last raised the rate, from 5.5% to 6%, in the first quarter of 1995.
At press time, analysts were anticipating that banks would respond by raising their prime rates, which are the basis for rates on various consumer and business loans, but none had.
Banks suffer in rising-rate environments because capital-raising and lending become more expensive. But "the 25-basis-point hike is relatively insignificant to the average bank," said bank bond analyst Eric Grubelich of Keefe, Bruyette & Woods.
Although some midsize banks rallied, big banks generally suffered in stock market trading. First Union Corp. shares fell $2.50 to $88.75. Bankers Trust New York Corp. fell $2.25 to $88. BankAmerica Corp. dropped $1.625 to $112.
Banks were expected to pass on much of the impact of the rate hike to their customers. Indeed, Sen. Tom Harkin, D-Iowa, blasted the increase, saying he was "immensely disappointed that Chairman Greenspan ignored the calls to keep interest rates steady.
"In one fell swoop, the Fed has taken money out of the pockets of every family, small business, and farm in America," said Sen. Harkin in a press release.
But Robert B. McKinley, president of Ram Research, Frederick, Md., said credit card issuers that lend to the higher risk customers could suffer.
"There is only so far you can push rates up to customers," said Mr. Mckinley. "If you keep pushing them up, you will get some backlash from customers and regulatory bodies."
Bankers at the Consumer Bankers Association's auto finance conference in San Diego, meanwhile, said most of the effects have already been felt in their business.
"We've seen it coming, and rates have already been adjusted," said Betty Trautwein, senior vice president at First Union National Bank, Charlotte, N.C., "It would take a raise of a half-point to significantly affect auto lending volume."
Bruce Ling, director of commercial lending at Credit Suisse First Boston, said he didn't think the moderate hike "will have a material impact on banks." But he added that if rates continued to spiral upward, the reactions of the bond and equity markets could be strongly negatives.
The Federal Reserve had no choice but to raise rates, because after this month there will be "no statistical report to justify a raise," said chief economist Thomas Carpenter of ASB Capital Management.
"The bond market has been telling the Fed that there needs to be a little tightening of the screws at the hinges of the door," said Mr. Carpenter. "Fed funds needed to be nudged up so that the bond market would not have to work so hard to manage economic growth."