How interest rates are set

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. It is in turn based on the fed 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.

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Prime rate, fed funds, COFI
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In the US, the Fed sets the fed funds rate (FFR) aka the target rate, and the overnight rate, or just the interest rate. This is the benchmark rate that banks use to figure their spread. The do this by adding their costs and profit based on risk to the base rate. The cost plus profit for the most creditworthy borrowers is the spread added to the FFR to arrive at the prime rate. This spread is ~3% for the prime rate. For example, the FFR is .25% and the prime rate is 3.25%. The rate charged less creditworthy borrowers is figured off the prime rate.

Therefore, although the Fed only controls the interest rate on reserves and not the amount banks charge for loans, it knows quite accurately how the prime rate will change with changes in the FFR. So it is by setting the FFR that the FED directly influences the rates that banks charge for credit. Owing to keen competition among banks, the prime rate is essentially the same for all banks and banks also are competitive in assessing risk to set rates for other borrowers.

The Fed has three options for setting the interest rate. It can:

• set the interest rate to zero;
• pay interest on reserves equal to the target rate;
• announce the target rate and adjust the supply of reserves available in the interbank market through open market operations (OMO), with the discount rate as ceiling, and with excess reserves have been drained through issuance of Treasury securities (bills, notes, bonds, and TIPS) through coordination with Treasury.

Ordinarily, the Fed uses OMO to hit the target rate. Presently, to the expansion of reserves because of quantitative easing (QE), the Fed is paying interest on reserves (IOR).

Some MMT economists, notably Warren Mosler, recommend that the Fed set the FFR to zero. See The Natural Rate of Interest Is Zero.

Update: Steve Randy Waldman sent a link to a post of his post via Twitter. It questions the prime rate as a benchmark rate. He offers a good rationale for thinking that the benchmark is LIBOR for the most creditworthy customers. The prime rate is only used as a benchmark rate for "the little people."

Is the Prime Rate a Scam?

Gov't spending, deficits, inflation and long-term rates. The truth, once and for all.

We've been told by the neoliberal-Austrian-hard-money-fiscal-conservatism propaganda crowd that we must fear excessive government spending and debt because that will inevitably lead to skyrocketing and crushing interest rates. It's a "given" we're told, pretty much.

Yet once again a simple analysis of past history reveals the TRUTH--that there is no such correlation between government spending and deficits and interest rates. In fact, there is even weak correlation between inflation and interest rates as I will show. The only real thing that we can see, quite clearly in fact, is that long term interest rates are anchored by Fed policy and nothing more.

At this point those of you who are familiar with MMT and how the Fed uses monetary operations to set interest rates, please feel free to shout the phrase, "Duh!!!"

That's right...because long term interest rates are nothing more than the expectation of Fed policy over the term in question and if rates have been set lower for the past 30 years (despite exponentially rising gov't spending, deficits and even fluctuating inflation), long-term rates will trend lower.

Please examine the following charts:

Chart 1. Government spending vs Long-term interest rates


Absolutely zero correlation between government spending, which rose nearly 10-fold in the past 30 years, and long-term rates, which went down 73% over the period.

Chart 2. Surplus/Deficits vs Long-term interest rates


This chart is pretty clear: long-term rates have continued to come down despite a humongous surge in the deficit.

Chart 3. Inflation rates vs long-term interest rates


I would say the relationship between inflation and long-term rates, at least by looking at this chart, is suspect. Rates did drop sharply along with a concomitant decline in inflation from 1980 to 1986, however, inflation has since hovered in the 2% to 4% zone while long rates have continued to decline.

Chart 4. Fed funds vs long-term interest rates


We can quite clearly see a very strong correlation between the central bank's overnight interest rate target (Fed funds) and long-term yields. And why not? As stated before the long-term yield simply reflects Fed interest rate policy over the term.