5 Factors Affect the Current Prime Rate

The current prime rate is the interest banks are charged for borrowing from one another. The prime rate is established by the Federal Reserve. The Federal Reserve is the bank that controls the flow of money and cash for all other banks and consumers. The Federal Reserve is heavily tied to the governmental demands and national policy; however, it is not controlled by the government entirely. It can establish its own policies on how best to manage the interest rate

Inflation

Inflation is a major factor the Fed considers when determining the prime interest rate. A lower interest rate is supposed to help curb inflation. The reasoning behind this is fairly simple: when banks charge high interest rates, the cost of a loan goes up over time. Costs going up over time are, at heart, what inflation truly is. Keeping costs low over time with low interest rates is one way to control how high prices adjust. Inflation is the biggest threat during a recession, and this is when the Fed generally lowers the prime rate.

Default Rates

A high amount of default on loans across the country may result in a lower interest rate on the federal level. For example, if home mortgage defaults are high, then mortgage lenders will risk going out of business if they have to repay their loans at high interest rates. To keep these lenders healthy, the Fed will offer them cheaper loans. The Fed aims to make it possible for lenders with good business practices to stay afloat, especially during a recession.

Credit Market Health

As default rates go up, lenders will start to pull back from the market. They will offer less loans to consumers. Businesses and households will stop making large purchases without the financing, and the economy will stoop into recession. In order to prevent this, the Fed attempts to encourage lending by making it very cheap for institutions. In the worst recessions, the prime rate will approach zero. This happens when the Fed agrees to make no profit at all on its own loans in order to keep other lenders active and profitable. 

Government Incentives

The Federal Reserve is highly tied to national policy. When the country as a whole decides it is time to encourage spending and lending, the Fed will generally follow. The only way the Fed can truly encourage lending with its limited scope of powers is to lower the interest rate. It is possible for the chairperson of the Fed to disagree with policy and take other steps, but this does not usually occur.

Financial Institution Solvency

The worst recessions threaten the solvency of banks and lenders. At that point, lenders may start going out of business. This is bad for the general health of the economy because most business and households, including the federal government itself, rely on debt to expand and get through points of low cash flow. It is in the best interest of the country to keep financial institutions healthy as they are the backbone of the economy. The Fed will lower interest rates when the current economy is threatening the health of banks and lenders.