That's because it impacts monetary and financial conditions, which in turn have a bearing on critical aspects of the broader economy including employment, growth, and inflation. As of Oct. 27, 2023, the current effective fed funds rate is 5.33%. When the Fed buys or sells government securities in the open market, it adds or reduces the amount of cash in circulation. This way, the Fed dictates the price of borrowing among commercial banks. Let’s say the committee agrees that the economy needs a boost and decides to reduce its target rate by a quarter of a percentage point. Bankrate.com is an independent, advertising-supported publisher and comparison service.
The FOMC makes its decisions about rate adjustments based on key economic indicators that may show signs of inflation, recession, or other issues that can affect sustainable economic growth. The indicators can include measures like the core inflation rate and the durable goods orders report. To do this, it buys a specific amount of government securities on the open market, infusing the financial system with cash. According to the laws of supply and demand, this influx of cash means private banks aren’t able to charge each other as much for loans. By law, banks must maintain a reserve equal to a certain percentage of their deposits in an account at a Federal Reserve bank. The amount of money a bank must keep in its Fed account is known as a reserve requirement and is based on a percentage of the bank's total deposits.
As you can see from the table, the prime rate has returned to the levels see before the Covid-19 recession. Over the longer term, the prime rate remains well below the highs seen over the last 20 years. Those include fixed rates for 30-year mortgages, corporate bond rates, and other long-term loans. The prime rate plus a percentage forms the base of almost all consumer and business interest rates. For example, a person with an outstanding credit score might be charged, say, prime plus 9% for a credit card, while an individual with only a good score might get a rate of prime plus 15%.
A significant change in the prime rate often signals that the Federal Reserve has changed the federal funds rate. It increases the federal funds rate to bring inflation under control. The prime interest rate, which is also called the prime lending rate, is largely determined by the federal funds rate set by the Federal Open Market Committee (FOMC) of the Federal Reserve. It is customary for the Federal Open Market Committee to meet eight times annually to determine the federal funds rate.
“Best in this sense are the borrowers with the least risk of default,” says Jeanette Garretty, chief economist and managing director at Robertson Stephens, a wealth management firm in San Francisco. It’s usually the lowest interest rate banks will charge and is a benchmark to determine interest rates for other products, like lines of credit, credit cards and small business loans. The federal funds rate is the rate banks charge each other for short-term loans. Banks use this rate as a starting point to set the prime rate for consumers. The prime rate is often roughly 3% higher than the federal funds rate (and currently 3.25%).
Rate hikes have been aggressive since May of 2022, so remaining on hold is the right thing to do. The last thing the Fed wants to do is drag the economy down into a deep recession. The highest prime rate ever recorded in the U.S. was 21.5%, which was reached in December 1980.
The prime rate is determined by the current federal funds target rate, which is set by the Federal Reserve. This rate guides the interest rates that banks charge each other when they lend money overnight to meet Fed capital reserve requirements. The end-of-the-day balances in the bank's account averaged over two-week reserve maintenance periods are used to determine whether it meets its reserve requirements.
The prime rate in Canada was 7.2% and 1.48% in Japan as of January 2024. These rates are normally defined as an annual percentage rate (APR). Yarilet Perez is an experienced multimedia journalist and fact-checker https://www.dowjonesrisk.com/ with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Her expertise is in personal finance and investing, and real estate.
Similarly, when rates are high, liquidity dries up, and the economy slows down. The prime rate had increased since May 2022, moving in tandem with the FOMC's increases to the fed funds rate to combat high inflation. The rates individual borrowers are charged are based on their credit scores, income, and current debts. For example, a small decline in the rate can prompt the market to leap higher as the borrowing costs for companies get lower. Many stock analysts pay particular attention to statements by members of the FOMC to try to get a sense of where the target rate may be headed.
These rates are influenced by economic indicators, such as the core inflation rate and the durable goods orders report, which provide signals about the economic health of the country. The FOMC increased the target fed funds rate to a range of 5.25% and 5.5% in July 2023. Although the economy is expanding and unemployment remains low, the FOMC remains cautious about the level of inflation, which remains elevated. “Decisions by a bank’s asset and liability committee will ultimately determine where those other rates will settle,” says Garretty. For example, if one bank wants more credit card business on their books while another does not, they will quote different credit card rates, even though they are working off the same prime rate. The prime rate is the interest rate banks charge their best customers for loans.
It is in turn based on the federal funds rate, which is set by the Federal Reserve. The COFI (11th District cost of funds index) is a widely used benchmark for adjustable-rate mortgages. The federal funds rate is the interest rate that banks charge each other to borrow or lend excess reserves overnight. The law requires that banks must have a minimum reserve level in proportion to their deposits. When a bank has excess reserve requirements, it may lend these funds overnight to other banks that have realized a reserve deficit. Debt with a variable interest rate can be affected by the prime rate because a bank can change your rate.
On the other end of the spectrum, a bank’s very best borrowers may be able to negotiate lower than the prime interest rate. This kind of negotiation happened more frequently in the 1980s, Garretty notes, when interest rates were much higher. Lenders would try to attract “blue chip” borrowers by offering interest rates lower than the prime rates. Of course, most credit cards set variable ranges for interest rates, meaning you can receive an APR anywhere on a preset scale, such as 12% to 24%. Consumers with excellent credit will likely qualify for rates as low as 12%, whereas someone with good credit may receive rates closer to 24%.
If a bank expects to have end-of-the-day balances greater than what's required, it can lend the excess to an institution that anticipates a shortfall in its balances. The interest rate the lending bank can charge is the federal funds rate, or fed funds rate. The prime rate is also important if you have any debt with a variable interest rate, where the bank can change your rate. This includes credit cards as well as variable rate mortgages, home equity loans, personal loans and variable rate student loans. If the prime rate goes up, the bank could end up charging you a higher interest rate so your monthly payment on variable debt would increase. The prime rate, as reported by The Wall Street Journal's bank survey, is among the most widely used benchmark in setting home equity lines of credit and credit card rates.
In 2022, to combat inflation, the Fed started raising its rate, which is a process that continued into 2023. The FOMC said these moves were necessary as indicators show the economy is expanding at a modest pace, job gains have been robust, the unemployment rate has remained low, and inflation remains elevated. If you happened to have a loan indexed to LIBOR, the effect was sizable. For instance, a homeowner with an adjustable-rate mortgage that reset during late 2008 may have seen their effective interest rate jump more than a full percentage point overnight. Meanwhile, the Federal Reserve was busy buying securities in an effort to bring down the funds rate for domestic lenders. The result was a significant split between the two rates before they once again converged.
Erika Rasure is globally-recognized as a leading consumer economics subject matter expert, researcher, and educator. She is a financial therapist and transformational coach, with a special interest in helping women learn how to invest. Daniel has 10+ years of experience reporting on investments and personal finance for outlets like AARP Bulletin and Exceptional magazine, in addition to being a column writer for Fatherly. David Rodeck specializes in making insurance, investing, and financial planning understandable for readers. He has written for publications like AARP and Forbes Advisor, as well as major corporations like Fidelity and Prudential.
