More interest rate ease-up seen. Fed action is predicted as prod to the economy

In banks, board rooms, and brokerages -- where interest rates are keenly followed -- perception is nine-tenths of the game. The prevailing perception is that interest rates are coming down, with or without a big reduction in the federal budget deficit. And the growing probability of a significant deficit cut in Washington encourages things even more, economists and bond-market specialists say.

The key interest rate to watch is the discount rate, which the Federal Reserve charges for loans to member banks. It is now 8 percent. Analysts predict the Fed will adjust the rate to 73/4 or 71/2 percent shortly in order to stimulate economic growth.

That would also be a reward to the Senate for taking a big step last week toward reducing the budget deficit.

Other rates would slide as a result, and in fact, according to Douglas McAllister, a government bond specialist at Prudential-Bache, the bond market has already built an anticipated discount-rate cut into its prices.

Tuesday's report of a smaller-than-anticipated increase in retail sales (0.9 percent) in April shows an economy still in need of some prodding, Mr. McAllister notes.

Today's data on industrial production, widely expected to be fairly sluggish, could also prompt the Fed to cut the discount rate. The Fed reviews credit policy next Tuesday at a meeting of the Federal Open Market Committee.

Bond prices have risen -- and interest rates fallen -- since last Friday, shortly after the Senate worked out a deficit reduction package. The stock market has also done well since Friday.

The bond market rally is being popularly billed as an endorsement of the Senate budget compromise. White House spokesman Larry Speakes noted Tuesday that ``the response from money markets to the Senate's historic budget vote shows just how robust the recovery will continue to be if the House of Representatives will now match the Senate's resolve to reduce budget deficits.''

``The budget package is a very important step forward,'' says Richard D. Rippe, senior vice-president and economist with Dean Witter Reynolds. ``[Fed chairman] Paul Volcker has told us that this is what is needed, and here is the start of the package.''

Mr. Rippe characterizes optimism on the bond market as ``widespread -- the markets are pleasantly receiving the budget deficit package.''

Though he warns that clearing the House and the inevitable conference committee is not a simple process, Rippe nonetheless thinks that by the third quarter of the year a full deficit-reduction package will be in place.

``And that is highly positive for the general economy,'' he notes. ``There will be more savings available for capital formation, lower interest rates, and less risk of the government resorting to inflation as a way of reducing the budget deficit.''

Economist Barry Bosworth of the Brookings Institution says that even if the more modest economic forecasts of the Congressional Budget Office are used instead of those of the White House, the Senate deficit reduction plan ``is a very big package.'' It moves the CBO projection of a $250 billion deficit by 1988 to $150 billion that year -- ``down the declining path,'' Dr. Bosworth notes. ``That would send a message to capital markets.''

``This is a significant action in getting the structural budget deficit down,'' Bosworth says. If a package of this magnitude emerges from Congress after it goes to the House, then Congress can say ``it did everything it could on the expenditure side, and next year they can go for a tax increase.''

Prompting the Senate action, the economist says, is the view that restoring America's competitive advantages in foreign trade may not be easy.

Many economists have argued that the federal budget deficit boosts interest rates and thus pushes up the dollar in relation to other currencies. That makes it harder for US goods and services to compete overseas. Reducing the budget deficit, the theory goes, would reverse this and help reduce the trade deficit.

But even if the federal deficit were reduced tomorrow, foreign goods have made such inroads on their US competitors -- and the dollar has reached such heights -- that the trade deficit would still be a big problem.

The Fed, Bosworth says, may decide to push interest rates ``lower than anticipated'' in order to affect exchange rates, stimulate the economy, and try to reduce the trade deficit.