The prime rate has different meanings in different contexts. It most commonly refers to a commercial bank's prime lending rate, or the interest rate charged by banks for short-term commercial loans to their most creditworthy customers. Different banks may have different prime rates, and specific loans may vary from the prime rate due to a number of factors. Banks use the prime rate as a benchmark in setting the rates for a wide range of loans, including small business loans, home equity loans, and credit card balances. Banks also refer to their prime rate as their base lending rate.
In the context of interest rates in general, the prime rate refers to the rate of interest that would be charged on a riskless loan. In a sense it represents the "pure" cost of money in the absence of financial risk. Comparing yields on a riskless investment, such as U.S. government securities, with those of other investments, such as corporate bonds, provides a measure of the interest rate premium that must be paid for assuming some financial risk.
In the case of Federal Reserve banks, their prime rate is the discount rate they charge to member banks for advances that are secured by U.S. government securities. The Federal Reserve Board, through its Federal Open Market Committee, may raise or lower its discount rate as a matter of monetary policy. The prime lending rate of commercial banks is sensitive to the Fed's monetary policies; increases in the discount rate are usually followed by major banks raising their prime rates. It should be noted, however, that when the Federal Reserve Board raises its discount rate, it is not actually raising what is commonly called the prime rate. Rather, it is individual banks that raise or lower their prime rates in response to changes in the Federal Reserve's discount rate.
Changes in the prime rate are usually made first by the nation's largest banks, after which other banks follow suit. In some cases a few smaller banks may raise or lower their prime rates on their own, but normally other banks do not follow along. Most of the large banks tend to have the same prime rate, and changes in the prime rate affect the interest rates charged by banks on other types of loans and credit as well as the interest paid on investments such as certificates of deposit. While rates on loans tend to rise quickly in response to increases in the prime rate, they are generally much slower to respond to decreases in the prime rate.
The Federal Reserve Board can influence the prime rate through its monetary policy. In general the Fed increases its discount rate in times of economic growth in order to slow the economy's growth and reduce inflationary pressures. In slow economic times, the discount rate is likely to go down. As was noted, banks tend to raise or lower their prime rates in response to the announced monetary policies of the Federal Reserve Board.
Since 1965 the prime rate has reached a low of approximately 5 percent in 1965 and a high of more than 22 percent in 1980. Depending on economic conditions the prime rate may be relatively stable, or it may change frequently. In 1965, for example, the prime rate changed once, while in 1980 it changed 37 times as it fluctuated from just under 12 percent to just over 22 percent. Between March 1989 and March 1994, the prime rate charged by banks declined steadily to a low of 6 percent before it began to rise again. It reached 8.5 percent in March 1997 and stayed there until October 1998, when it was lowered to 8.25 percent in response to the Federal Reserve Board lowering its discount rate to 5.25 percent.
[ David P. Bianco ]
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Dugas, Christine. "Rate Flux Has Far-Reaching Potential." USA Today, 26 March 1997, BIO.
Murray, Matt. "Prime Rate Cut by 0.25 Percentage Point." Wall Street Journal, 1 October 1998, A3.
Selz, Michael. "Financing Small Business: Gap with Prime Rate Grows on Smallest Business Loans." Wall Street Journal, 11 February 1997, B2.