A Light Turns On for the Fed : Small interest rate cut may mark start of crucial change

Signaling concern about the nation’s lackluster economy, the Federal Reserve Board cut a key short-term interest rate last week--the first time it has lowered an interest rate in nearly three years. It was a slight, prudent cut, but it could mark the beginning of a significant change in Fed credit policy.

Wall Street soared, Main Street cheered. In California, where the economic recovery remains fragile, the sigh of relief was collective and loud. Typically when the Fed changes course it follows with more moves in the same direction. That could mean more interest rate cuts soon, to California’s benefit.

The reduction--a quarter of a percentage point in the federal funds rate that banks charge each other for overnight loans--represents a hedge for the Fed. It is sufficient response to new indications of an economic slowdown but not too strong in light of contrarian opinion that a rebound is imminent. Indeed, there was a hint of strengthening in June’s national unemployment rate decline to 5.6%, the lowest rate in three months.

Before the Fed acted last Thursday, some of its critics were concerned that the board would wait until August to cut interest rates, when its next policy-making Open Market Committee meeting is scheduled. By moving earlier, the Fed acknowledged concerns that its carefully engineered “soft landing” for the economy (seven interest rate hikes between February, 1994, and February, 1995) could easily turn into a recessionary thud.

“As a result of the monetary tightening started in early 1994, inflationary pressures have receded enough to accommodate a modest adjustment in monetary conditions,” Fed Chairman Alan Greenspan said in announcing his board’s change of direction. Within a day of the Fed’s cut, most large banks reduced their prime lending rate, the benchmark for many consumer and business loans. Generally, it takes a number of months for such a change to be reflected in lower consumer interest rates, increased business activity and new jobs.

The psychological impact of the Fed’s action may be just as important as the actual drop in interest rates. Consumer confidence is low, workers are worried about their jobs and retail sales are in the tank. Californians especially are bothered by uncertainties: the possibility of more military base closures, declining property values, the Orange County bankruptcy and possible layoffs of Los Angeles County employees because of the county’s budget problems.

When the Fed was tightening credit, the policy worked against California’s fledgling economic recovery and favored other, economically robust regions. As California struggled with one of the highest unemployment rates in the country, states like Wisconsin, where joblessness is among the lowest in the nation, were struggling with a shortage of labor. For example, hamburger flippers at eight McDonald’s in Madison, Wisconsin’s capital, are earning $6.50 an hour, about 50% above the minimum wage. Such are the regional contradictions of the massive U.S. economy.

A firm recovery in California, fostered by lower interest rates, undoubtedly would fuel the nation’s economic progress. The state’s crucial importance to the national well-being is something Greenspan and other Fed officials should keep in mind as they approach their August meeting and weigh yet another cut in interest rates.