Interest Rates Come Tumbling Down

Lower Discount Rate Seen as Weak Medicine

By reducing two key interest rates on Wednesday, the Federal Reserve signaled its determination to recharge the economy. But some experts doubted the move would have the intended result.

The Fed cut the discount rate rate to 4.5% from 5% and reduced its target rate for overnight fed funds to 4.75% from 5%. Banks borrow from the Fed at the discount rate and lend overnight to each other at the fed funds rate.

Dozens of banks took a cue from the Fed and cut their prime lending rates to 7.5% from 8%.

Bush administration officials applauded the moves, which were expected for nearly a week.

"Lower interest rates will provide stimulus for economic growth, spur incentive for business investment, and increase consumer confidence," Treasury Secretary Nicholas Brady said in a prepared statement.

The long-term bond market displayed less enthusiasm. Although short-term rates fell, long term rates barely moved. The 30-year bond was trading at 8% Wednesday afternoon, two basis points below Tuesday's.

A Sharp Yield Slope

The yield curve is now more steeply sloped than it has been in years - "a ski slope," according to one economist.

That means investors are still worried about the high volume of government borrowing and the long-term outlook for the debt-heavy U.S. economy. They are going to continue to demand high rates on long-term securities, thereby keeping interest rates at levels guaranteed to put a damper on capital spending.

"The financial imbalances in our economy will simply take time to work themselves out," said Henry Engler, a vice president and money market economist at Chemical Banking Corp. "The accumulation of debt in the 1980s was high, and it will take a number of years for households and businesses to rebuild their balance sheets."

No Long-Term Lever

The Fed has no direct means of influencing long-term rates, which are governed by factors such as investors' worries about inflation and the supply of Treasury securities. And the government's large and growing deficit is being financed with huge sales of Treasury notes and bonds.

As a result, the yield on the 30-year Treasury bond is down just a quarter of a point since the beginning of the year, compared with a drop of two-and-a-half percentage points in the overnight fed funds rate. That means long-term capital investments are still costly to finance, so companies will be less inclined to undertake them.

"I think the deficit is at the heart of this problem," said Ward McCarthy, a managing director at Stone & McCarthy Research Associates. "If policymakers want to get long-term rates lower to support the housing market and business investment, I think the burden falls on the Treasury to lower the size of its borrowings."

Meanwhile, rates on many consumer loans remain high. Even with Wednesday's cut, the prime rate is now 300 basis points above the discount rate, much more than the spread of 150 to 175 basis points that normally prevails - meaning that consumers' borrowing costs have fallen less than other rates.

If consumers and businesses lack an incentive to borrow and spend, it will be hard for the economy to build up steam the administration is counting on.

"I'm not sure that easing monetary policy 50 basis points at a time is going to be sufficient to turn the economy around," said Charles Lieberman, director of financial markets research at Manufacturers Hanover.

Even though it was expected, the Fed's move came a bit sooner than many experts were predicting. Most Fed watchers had expected the central bank to wait and cut rates after the Treasury completed its three-stage auction of new notes and bonds, but the easing took place the day before the new 10-year notes and 30-year bonds were sold.

Motives Examined

Some said the central bank cut rates because the Treasury's sale of three-year securities - the first stage of the auction - went so poorly Tuesday afternoon. Treasury market specialists said many prospective buyers stayed away from the sale because they were disappointed that the Fed had not yet cut rates, and the notes were priced at a yield well above what had been expected.

But others said the Fed did not appear to be responding to unusual factors. They said the central bank simply waited until Tuesday's meeting of the Federal Open Market Committee. When a majority of governors favored an easing, the Fed acted.

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