NEW YORK — Short-term interest rates fell sharply Tuesday in an astonishing reversal that stunned economists and touched off predictions that mortgage and consumer loan rates may fall precipitously.
Two banks that raised their prime lending rate by a half-point only last week, Chemical and Marine Midland, took the unusual step of pulling back amid criticism over their move. The bond market rallied. And yields on short-term Treasury bills tumbled almost one full percentage point, a remarkable decline for a single day.
"All manner of interest rates are down, and everything that bothered the stock market reversed itself in a single day," observed Irwin L. Kellner, chief economist for Manufacturers Hanover Bank. "That is quite a record."
Not Easy to Predict
Although predictions are virtually impossible in an environment that allows the Dow Jones industrial average to fall 508 points one day and rise 102 the next, economists now say they expect rates to fall still further, for at least several weeks.
"The interest rate outlook is very important to market psychology," said UCLA economist Larry J. Kimbell. "With this reversal, I would say we've just seen the beginning. Interest rates are going much lower."
Kimbell's predictions: 9% fixed mortgage rates, 3% short-term Treasury bills and 7% long-term government bonds within the next few months. Fixed mortgage rates are now running over 12% in some instances, Treasury bill rates are 5.8%, and 30-year U.S. government bonds are 9.5%
"I called my mother early this morning and told her to take her money out of CDs (bank certificates of deposit) and go get long bonds," Kimbell said. "I'm betting that the (Federal Reserve) Board is going to actively give us lower rates."
At the heart of the interest rate free-fall was Monday's stock market crash.
Investors' concerns over higher interest rates were fodder for the epic collapse. And on Tuesday, the collapse became fodder for lower rates.
'Flight to Safety'
After the Dow Jones average of 30 blue-chip stocks took a 508-point beating on Monday, the nation's concerns turned away from rising interest rates and inflation and toward the prospect of a full-fledged economic depression, or at least a recession. Investors, in what market analysts called a "flight to safety," switched their money from stocks to less risky government securities, a move that sent rates on these securities down sharply.
Seeking to allay these investor fears, the Federal Reserve pledged before the stock market's opening Tuesday to take whatever steps are needed to ensure the soundness of the financial system. And the prospect of a looser monetary policy by the Fed in turn sent interest rates lower.
In just 30 minutes Tuesday morning, the price of 30-year government bonds rose $4 for every $1,000 in face value, "a move so incredible I was sure I must have read it wrong," said Security Pacific Bank economist Kathleen Cooper.
Chemical and Marine Midland lost no time responding to the Fed's promise of cheaper money. Within minutes, the only two major banks to have raised their prime lending rate to 9.75%--a half-point higher than the prevailing rate--announced that they had rolled back the prime to 9.25%.
Both banks cited the decline in short-term interest rates over the previous 24 hours--declines that had cut their own costs and thus allowed them to offer cheaper rates on loans to consumers and businesses.
But economists at other banks offered a slightly different version. One prominent bank economist noted that Chemical had been "roundly criticized for contributing to the turbulence" in the marketplace--even by other banks--and was now seeking to undo the damage to its reputation.
Chemical was the first to raise the prime. Most banks had raised the prime rate to 9.25% from 8.75% just a week earlier. Only Marine Midland followed Chemical's move even higher.
"Unfortunately for Chemical, they made the decision (to raise the prime) when CD rates hit a peak," said Security Pacific's Cooper. "Not long after, CDs started down again . . . when it became clear that the Fed was not going to raise the discount rate"--the rate at which the Fed lends to commercial banks.
No one was suggesting Tuesday that government officials nudged Chemical and Marine Midland into their unusual, but not unprecedented, decision to rescind the increase for the greater good of the country.
"I really believe the government practices its policy of keeping out of the marketplace," said another banker. "Chemical, especially, realized too late that they had gotten out ahead of themselves, and they were dying to find a way to get out of this mess; they didn't need to be pushed."
Expect 5.5% Discount Rate
Just five days after the markets were abuzz with gossip about the Fed possibly raising the discount rate, economists were predicting Tuesday that the discount rate may soon fall to 5.5% from 6%. Likewise, many predicted a prime rate as low as 8.25% before year-end, and lower mortgage and consumer rates as well.
But all outlooks were not rosy Tuesday.
"Yes, rates are going to be down for a while, but they have not yet peaked," economist Kellner predicted. "Inflation is still flaring up, and a recession sometime in 1988 is more likely now than ever before."