Prime Rates & The Federal Reserve
Lately, interest rates have been a hot topic, even in the mainstream media. Each new rate change announcement from the Fed brings a flurry of news reports. Unfortunately those reports don’t take the time to explain all the details. Understanding how and why the prime rate is established is an important component to understanding the overall impact of interest rates on bond and equity markets.
The Federal Reserve, which was founded in 1913 as the central bank of the United States, establishes interest rates. The Fed’s stated purpose is “to provide the nation with a safer, more flexible, and more stable monetary and financial system.” Monetary policy, such as establishing interest rates, are made by the Federal Open Market Committee (FOMC), which consists of the Board of Governors of the Federal Reserve System and the Reserve Bank presidents. The FOMC holds eight meetings per year at which they review economic and financial conditions in order to determine an appropriate monetary policy.
The Federal Reserve Bank offers three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. Primary credit rates (prime interest rate) are established for short-term loans (usually overnight) to depository institutions in sound financial condition.
Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.
Higher interest rates are generally negative for stocks. Higher rates tend to slow down economic growth and adversely impact corporate earnings. In addition, they usually raise the yield on new issue bonds and money market funds.
Conversely, lower interest rates are generally good for stocks. With the reverse of increased economic growth and higher corporate earnings being the case. As expected, lower rates also decrease the yield on new issue bonds and money market funds.