A rise in the prime and other lending rates before yearend became increasingly likely after government reports Friday showed surprisingly strong gains in jobs and wages.
The employment data for May improved the odds that the Federal Reserve will move to boost short-term interest rates, and banks rates would be expected to follow.
"If the Fed pushes the federal funds rate 50 basis points higher, the prime would move up basis point for basis point," said Lawrence Cohn, bank analyst at Paine Webber Inc. " The industry has no tolerance for absorbing a hit."
Picking Up Steam
Most banks have had their prime rates at 6% since July.
Higher loan rates seemed unthinkable a few months ago, as the economy sputtered after a torrid fourth quarter of 1992.
But the economy has picked up steam, conjuring up the specter of more rapid inflation, which would cause the Fed to tighten.
Even employment, which has not rebounded strongly from the recession, is starting to grow.
The Labor Department said Friday that nonfarm payrolls grew by 209,000 in May, bolstered by construction and service jobs. The unemployment rate fell to 6.9% from 7% in April.
Meanwhile, April's report was revised to show a 216,000-job increase, rather than the originally reported 119,000.
In another eye-catching part of the report, average hourly wages rose 0.66% in May. Economist had expected a more moderate increase.
"The door is open for the Federal Reserve to raise short-term interest rates to either combat inflation or protect the dollar," said Hugh Jonhson, chief market strategies for First Albany Corp.
"A failure to act would ratify the Fed's acceptance of inflation," said William Hummer, economist at Wayne B. Hummer & Co., a Chicago-based brokerage.
An inflation scare has been evident in the financial markets, with each bit of news about risking prices causing interest rates to spike higher.
Friday, the yield on the 30-year Treasury bond rose to 6.9%, from 6.8% at Thursday's close. Short-term rates moved higher as well, with the bond-equivalent yield of three-month Treasury bills rising to 3.18% from 3.08%.
The next major inflation indicator - the May producer price index - is due Friday. The next consumer inflation report comes out June 15.
John Lonski, senior economist at Moody's Investors Service, predicts that the Fed will tighten twice before yearend, raising its target for the federal funds rate first to 3.25%, from 3%, and later to 3.50%.
Fed's Monetary Policy
The Federal Open Market Committee, which sets monetary policy, reportedly moved to a pro-tightening stance at its meeting late last month.
Many economists think banks would likely ignore a fed funds move to 3.25%. But if the Fed raises the funds rate target to 3.5%, they say, bank rates would rise in tandem.
David Lereah, economist for the Mortgage Bankers Association of America, noted that, if the funds rate goes that high, mortgage rates would rise by about a quarter point from the current 7.5%.
However, he does not think the jobs report justifies a tightening, and he expects mortgage rates to remain firm.
Tighter money is widely seen as big news for banks because their record profits in recent years have depended heavily on the wide spreads between short-and long-term interest rates. Most economists expect short rates to increase more sharply than long rates, which should pinch banks' net interest margins.
"The process has already begun," said Mr. Hummer, noting the quarter-percentage-point increase in three-month Treasury bill rates in recent weeks.
But some analysts believe banks have built up comfortable cushions.
Banks traditionally kept their prime rates at 170 basis points over the fed funds rate, said Mr. Lonski of Moody's. For about the last year, the spread has been 300 basis points.
An improvement in loan demand, in tandem with a stronger economy, could offset the effects of a flatter yield curve, Mr. Lonski added.
Mr. Cohn of PaineWebber said he has not adjusted any earnings estimates because of the prospective rate changes. "Our view is that a tightening won't have a noticeable impact on earnings," he said.
Increases in money market rates do not automatically translate into higher funding costs. Tom Coan, president of the Federally Insured Savings Network, a Washington-based firm that sells certificates of deposit and other instruments, noted that certificate of deposit rates have not risen noticeably in recent weeks.
Lack of competition for funds among banks and thrifts, as well as federal regulation, constrains deposit rates, Mr. Coan said.
Weak CD Pricing
"Money market forces are not always relevant to the banking community as a whole," Mr. Coan said. "Financial institutions don't need the money anymore."
In the past, money brokers sold one-year CDs at spreads of 150 to 300 basis points over 30-year Treasuries. That would mean rates of 8.50% to 10% today.
"Making common mortgage loans does not require that kind of rate," Mr. Coan said , adding that one-year CDs in fact are closer to 4%.