Why Does the Federal Government Adjust the Prime Interest Rate?
The U.S. Federal Reserve does not adjust the prime interest rate, it adjusts the federal funds interest rate. Banks then adjust their prime interest rates depending on the movement of the federal funds interest rate. To understand why the Fed adjusts the fed funds interest rate, you need to learn about the connection between the federal funds interest rate and the prime interest rate.
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Federal Funds Interest Rate
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The federal funds interest rate is a short-term rate banks and depository institutions charge each other for overnight lending. At the close of business every day, the Fed requires all depository institutions to have a certain amount of cash on hand to cover its deposits. This is a reserve limit. If a bank is short on its reserve limit, it obtains an overnight loan from another bank to meet the Fed requirements. The Federal Reserve sets the federal funds interest rate.
Prime Rate
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The prime interest rate is a determination made by banks. The Wall Street Journal has a prime rate bank survey that gives investors the average prime rate banks are charging across the nation. The prime rate is generally at three percent above the federal funds rate. For example, if the federal funds rate is .5 percent, the prime rate is usually right around 3.5 percent. The prime interest rate is what banks charge their most creditworthy customers on loans.
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Consumer Spending
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The Fed adjusts the federal funds interest rate lower, leading banks to decrease the prime interest rate. Both the Fed and the banks do this in order to increase consumer spending. With low prime rates, consumers owe less interest on their loans. This lowers their payments and increases disposable income. Higher disposable income increases consumer spending, which, in theory, helps fuel a healthy economy.
Inflation
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When consumer spending increases too much it leads to rising prices, which then leads to inflation. The more consumers and businesses spend, the more inflation increases. In response to inflation, the Fed increases the federal funds rate, leading banks to increase their prime rates for borrowers. This tightens credit, increases loan payments and decreases disposable income. Consumers borrow less and spend less. When spending drops, it prevents inflation from rising any higher.
Securities
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When the Fed adjusts interest rates higher, spending decreases and prices for securities fall. Initially, falling stock prices have a negative effect on the market. When securities prices fall low enough, investors begin to buy, reversing the initial negative affect on the markets. This increases securities prices, consumer spending and stimulates the stock market. In the bond market, the reverse is true. When the Fed adjusts interest rates higher, bond prices drop. When they adjust interest rates lower, bond prices increase.
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References
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