Discount-Rate Cuts

Discount-Rate Cuts

Discount-Rate Cuts

Moneybox
Commentary about business and finance.
Nov. 17 1998 6:51 PM

Discount-Rate Cuts

The Fed's decision today to cut the fed funds rate by a quarter point had been expected on Wall Street, and had that been the Fed's only move it's unlikely that the stock market would have responded to the decision as positively as it did. What investors may have seized upon was the Fed's decision to also trim the discount rate--the rate banks charge each other for overnight lending--by a quarter point, to 4.50 percent. That's the second straight discount-rate cut for the Fed, and although the rate itself is not of dramatic importance in the actual functioning of the economy, it has real weight as a symbol of the Fed's ideas about where the economy is going.

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In other words, what the discount rate cut suggests is that the Fed may not be done trimming interest rates, and that it believes the economy will slow substantially in 1999. The cut is therefore a double-edged sword for the market, since it suggests both that corporate profits will come under continued pressure next year and that the Fed is on the case to keep that pressure from becoming too great. The three successive fed-funds cuts are pumping liquidity into the economy, and Alan Greenspan is doing his best to avoid presiding over another recession. Trimming the discount rate, then, was a way of signaling the Fed's resolve, which itself should help consumer and business confidence.

The change in the Fed's general attitude is, as we've remarked before, genuinely striking. For most of his career, Greenspan was an inflation hawk, and the old-school Greenspan would hardly have looked at an economy growing at 3.3 percent, with an unemployment rate of 4.6 percent, and imagined that anything other than a rate increase was in order. But the combination of Greenspan's conviction that productivity is rising faster than the statistics measure, that turmoil abroad will have a material effect on the United States, and that investors have become unnecessarily risk-tolerant have all shifted the Fed's bias toward easing at seemingly every opportunity. Bond yields of close to 3 percent now seem completely within the realm of possibility, and if interest rates do drop that low, stocks will look more attractive than ever. Investors who have been looking for any reason to buy just found another one.