The Federal Reserve Board, deeply worried about the state of the economy and the possibility of some new shock to the nation's financial system, yesterday cut its discount rate from 8 percent to 7 1/2 percent effective Monday.
The action is expected to encourage generally lower interest rates and to spur lagging economic growth. It also provides room for some other nations, such as Britain and West Germany, to reduce their own rates in order to give their economies a boost and to increase the market for U.S. goods there, financial analysts said.
Lower interest rates also provide relief to troubled financial institutions, such as Maryland's privately insured thrift institutions, by increasing the current value of the mortgages they hold. At the same time, it will lower their cost of obtaining funds from depositors or directly from the Fed.
At 7 1/2 percent, the discount rate -- the interest rate the Fed charges when it lends money to financial institutions -- is at its lowest level since August 1978.
The reduction in the discount rate ensures that a cut in the prime lending rate from 10 1/2 to 10 percent -- touched off Wednesday by Bankers Trust Co. -- will spread throughout the banking system. Citibank, the largest bank in the industry, announced after the Fed action yesterday that it was cutting its base lending rate effective Monday.
The Fed said its action "was taken against a background of relatively unchanged output for some time in the industrial sector of the economy stemming heavily from rising imports and a strong dollar.
"Price pressures, while clearly a continuing concern in some areas, appear to remain relatively well-contained in goods-producing sectors of the economy and sensitive commodity prices are generally at the lowest levels in about two years," the statement said.
"Growth of the monetary aggregates has slowed appreciably, although M1 has remained somewhat above the path implied by the annual targets," it continued. M1, the most closely watched measure of money, includes currency and travelers checks in circulation and checking deposits at financial institutions.
"In this setting," the statement concluded, "a reduction in the discount rate consistent with the decline in market interest rates over recent weeks appears appropriate."
The seriousness with which Fed officials view the current economic and financial situation was underscored by the fact that the board acted on the eve of a regularly scheduled meeting of its policy-making group and with two of the seven Fed governors out of town.
Jerry Jasinowski, chief economist of the National Association of Manufactuers, was delighted with the rate cut. Many NAM members are facing great difficulty competing against imported goods.
"I think it's great news because it indicates explicitly that the Fed is going to loosen monetary policy enough that interest rates will decline further and that economic growth will be supported. It reflects a realization on the part of the Fed that economic growth, particularly in the industrial sector, will be very slow in the second quarter and that there are no clear signs of a rebound on the horizon," Jasinowski declared.
Many financial market analysts had been expecting some type of Fed action to push interest rates lower, but few thought it would come before Tuesday's meeting of the Fed's policy-making group, the Federal Open Market Committee.
Some market rates already had declined in anticipation of a Fed move, so how much further rates will fall as a result of yesterday's discount rate cut is not clear, analysts said. However, with this strong signal of Fed intentions, some key short-term rates might fall in "lock-step" with the discount rate, an analyst at one New York government securities dealer said.
"The case for having a discount rate cut now has become compelling," the analyst said. "The economy is more sluggish than expected and the sluggishness is spreading. It's the dollar that is hurting the economy in many ways and action sooner is necessary rather than later."
The Fed had the room to move on rates, he continued, precisely because the economic news has been as pessimistic as it has and there are few signs of rising inflation. "It is hard to generate much concern in financial markets about inflation right now" even with the central bank aggressively seeking lower interest rates, he said.
In addition, there has been a change in mood in foreign exchange markets, with participants now expecting the value of the dollar to hold its own or rise. A few weeks ago sentiment was running against the dollar and some Fed officials were concerned that an aggressive move toward lower rates could trigger a collapse that, in turn, could set off a new spurt of inflation.
Lower interest rates make the dollar less attractive to foreign investors, lowering its value on currency markets and eventually helping to reduce the trade deficit.