The prime rate refers to the interest rate that banks are willing to charge their most creditworthy customers. It is an important metric that affects a lot of other variables in the economy. Even people who are debt-free and are not planning to borrow money any time in the future may see the effect of the change in the prime rate.
This rate itself is largely dependent on the overnight rate that is set by the Federal Reserve in the United States. Since the prime rate is largely affected by the overnight rate, the decisions of the Federal Reserve may affect the prime rate and all other interest rates in the US economy.
Even though the prime rate is dependent on the overnight rate, the prime rate may vary from bank to bank because each bank tends to set its own prime rate. Because of that, an individual looking to borrow money should shop around and see what different lenders have to offer before choosing a lender.
On the other hand, a change in the prime rate will change all other interest rates regardless of the lender. Since the overnight rate affects the prime rate, which affects all other interest rates, it is important for individuals to look at what the Federal Reserve is doing to see where the economy is headed.
The Federal Reserve has two main objectives: maintain the inflation rate at a certain level and maintain the unemployment rate at a certain level. Currently, the Fed focuses on maintaining the inflation rate because the US economy has seen a higher than expected inflation rate of 6.8% during 2021.
What Does Prime Rate Affect?
The prime rate affects many economic variables. The Fed uses overnight rates as a tool to control where the economy is headed to. The prime rate affects all other interest rates. This means that if the prime rate increases, the cost of borrowing for both businesses and individuals increases as well.
When the cost of borrowing increases, individuals and businesses may not be able to spend as much as before, which leads to lower demand for various products. Since the demand for the products decreases, the prices tend to decrease as well, which leads to a lower inflation pressure, which has been on the rise during the year 2021.
Not only consumer products tend to decrease in value when the prime rate increases. Housing and stocks are the two most common assets that individuals possess. The housing market tends to see a decline in growth rate as fewer people can afford to buy properties as the cost of borrowing increases.
Additionally, the stock market tends to decrease for reasons related to the prime rate. When the prime rate increases, interest rates for bonds increase as well. Many investors tend to move from risky assets like stocks to less risky assets like bonds when interest rates increase.
Additionally, many investors change their beliefs on various companies due to an increase in the prime rate. These two factors are responsible for a decrease in the stock prices when the prime rate increases. Both markets may experience a decline due to higher prime rates, which may decrease consumer spending.
Companies are also affected by the increase in the prime rate. Companies tend to have an investment schedule. If the prime rate increases, some companies may need to readjust their schedule to meet the optimal level of return. Since their cost of borrowing increases as the prime rate increases, some companies may choose to postpone certain investment operations.
This may lead to an even larger decrease in the demand contributing to the downward pressure on inflation.
Prime Rate in 2022
During the year 2021, the US economy has seen a higher than expected inflation rate. Consumer Price Index, a measure of prices for a basket of goods, has increased by 6.8% in November 2021 compared to November 2020.
Given that the Fed’s objective is to maintain the average inflation rate at around 2% in the long term, the inflation rate has been way above the target for most of 2021. Because of that, the Fed announced that it is planning to increase the overnight rate 3 times during 2022. These hikes will be reflected in the increased prime rate.
Given that the current prime rate is set at around 3.25%, and the Fed is planning to conduct 3 rate hikes that usually increase the overnight rate by 0.25%, the US economy may face the prime rates of around 4% – 4.25%.
This increase in the prime rate will increase the cost of borrowing for individuals and businesses, which may decrease the prices of housing and stocks. Due to a decrease in the assets held by the individuals, the individuals will likely decrease their spending on products and services.
This increase in the prime rate will create downward pressure on the inflation rate by decreasing the demand for products and services. Additionally, certain firms may be affected due to high levels of debt and investments.
An increase in the prime rate may put some firms out of business if they cannot meet their obligations given the new rate. On the other hand, the firms that can operate with a new prime rate may postpone their investment decisions to a later time.