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Federal Reserve changes course, cuts key rate


Faced with a growing risk of recession, the Federal Reserve reversed gear yesterday after a year and a half of tight money, cutting a quarter-point from a key short-term interest rate.

Financial markets responded by rocketing to record highs, and economists greeted the decision as the opening of a new period of a gradually easing money supply.

"I think this is the beginning of a period of loosening money, because the economy is still slowing down in response to the seven interest rate increases the Fed ordered from February 1994 to February 1995, so now easing is called for," said Alfred G. Smith III, chief economist for NationsBank Corp.

Yesterday's decision brought the federal funds rate, which banks charge each other for overnight loans, down to 5.75 percent from 6 percent, where it had been since the Fed boosted rates in February.

The Fed now can be expected to ease the federal funds rate to about 4.5 percent over a period of months, Mr. Smith said. "That is the level where I think we would see what the Fed wants, moderate growth with little or no inflation," he said.

"As a result of the monetary tightening initiated in early 1994, inflationary pressures have receded enough to accommodate a modest adjustment in monetary conditions," Fed Chairman Alan Greenspan said in a statement accompanying yesterday's announcement.

Wall Street, where stock and bond prices had been soaring for months partly in anticipation of easier money, reacted within seconds of the announcement.

The Dow Jones industrial average shot up more than 25 points within the first five minutes after the 2:40 p.m. announcement and went on to end the day with a gain of 48.77 points at 4,664.00, the second record in as many days.

The bond market also shot up, driving the yield on the benchmark 30 1/4 -year U.S. Treasury bond down by 9.77 basis points to 6.50 percent, a sign that long-term investors may see the Fed's change of direction as confirmation that inflation is under control.

Consumers can expect to feel the reduction in the form of slightly lower costs for variable-rate and new fixed-rate mortgages, which closely parallel bonds, and in eventual reductions in credit card and other variable charges.

Fixed-rate 30-year mortgages carried slightly higher interest rates averaging 7.63 percent last week, the government reported yesterday, but if long-term bond yields drop further, mortgages would come down with them, analysts said.

Banc One and Bank of America Corp., two of the country's biggest banking companies, immediately announced cuts from 9 percent to 8.75 percent in their prime rates, which are the base for many other charges, including interest on credit cards.

Business executives, especially at retail firms, took the news as a sign that relief from slower sales may be on the way.

"We should see the economy start to pick up again, especially big-ticket purchases, which have been off substantially this spring and summer," said Walter K. Frazier, vice president for marketing of Stansbury Decker System Specialists, a Baltimore-based firm that sells and installs home satellite dishes. In the past few months, higher interest rates "have really put the brakes on not only houses and cars but also our 18-inch satellite dishes," which cost just under $1,000 installed, he said.

The slowing of the economy was visible in government economic figures that were published as the 12 members of the Fed's Open Market Committee gathered yesterday for the second day of their meeting.

The Commerce Department reported yesterday that its Index of Leading Indicators, the government's main economic forecasting tool, declined by 0.2 percent in May.

The number was well within economists' forecasts, but it was the fourth straight monthly drop, and any three straight monthly declines are usually taken as a warning that a recession may be coming six months or so later.

But another key indicator, new claims for unemployment assistance, remained flat in June, the Labor Department reported.

With signals from the economy still a puzzle, economists cautioned that yesterday's move -- the smallest available to the Fed other than simply standing pat at 6 percent -- suggested that Fed members are still in deep disagreement about where the economy is headed.

They noted that the Fed did not touch the other key interest charge, the rediscount rate, which it charges banks, and avoided all mention of the economy itself in Mr. Greenspan's statement, sticking only to the inflation question.

"My interpretation is that there must have been a lot of disagreement, because this has the look of a compromise," NationsBank's Mr. Smith said. "If they were in agreement on where the economy is, the chairman's statement would have mentioned the economy, and [would not have] been so carefully limited to the receding threat of inflation."

"Greenspan tends to be an inflation hawk, and I suspect that if it were not for the strong and very public stand taken by [Vice Chairman Alan] Blinder last week, he would have stood pat. But now we're getting into the election season and the chairman's own reappointment comes up next year, and I truly believe that if he let the economy go into a tailspin with President Clinton facing re-election, he would be out of that job," said Michael A. Conte, director of regional economic studies for the University of Baltimore.

For Maryland, the cut may be "too little and too late," said Charles McMillion, president of MBG Information Services, a Washington-based consultancy that tracks the state's economy.

"Weak profits and weak personal incomes still lie ahead because the Fed waited so long, and Maryland is affected by that more than most states, but I guess any loosening is better than none," Mr. McMillion said.

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