A prime rate is the minimum interest rate banks are willing to charge their most creditworthy clients. It is largely based on the overnight rate that the Federal Reserve sets. Even though it is significantly affected by the overnight rate, prime rates may differ between the banks because they are set by each bank individually.
The prime rate is one of the most fundamental metrics for all other interest rates such as credit card interest rates, loan rates, and mortgage rates. Because it has such a great effect on all interest rates an individual may face, it is important to understand where it is right now and what is likely to happen to it in the future.
The Federal Reserve has control over the overnight rate, which affects the prime rate, which in turn affects all other interest rates in the economy. The Fed does not set overnight rates randomly. It is a tool the Fed has to control the inflation rate and unemployment rate in the US. A change in the prime rate affects economic activity in many different ways, and this article focuses on how the changes in the prime rate will affect consumers in 2022.
How Does Prime Rate Affect a Consumer?
A change in the prime rate will affect many parts of the economy to an extent that even a debt-free person may feel the difference due to the change. The intuition behind this relationship is as follows. When the prime rate increases, all other interest rates increase as well, which means that borrowers cannot borrow as much as they used to before the increase in the prime rate. Since they cannot borrow as much, they cannot spend as much as they used to. This lower demand for products makes the producers lower their prices. Lower prices mean a lower inflation rate.
On the other hand, since an increase in the prime rate affects all borrowing costs, the businesses may not be able to borrow as much and thus grow as fast as they could. Because of the slowdown in growth, fewer jobs are created, which may increase unemployment levels.
Asset prices such as housing prices and stock prices also get affected by the change in the prime rate. Since an increase in prime rate increases mortgage rates, there may be fewer individuals who are willing to purchase a house when the prime rate increases. Because of the fall in demand, housing prices are likely to decrease. Stock prices also tend to correlate with the change in the prime rate. Various interest rates are used in evaluating the value of a stock. Usually, interest rates have an inverse relationship with stock prices, so it is reasonable to assume that stock prices tend to decrease when the prime rate increases.
The prime rate changes affect inflation and unemployment rates, and The Fed has the objective to control both of these rates. This means that given recent events, we may infer how the prime rate will change as The Fed reacts to the data on inflation and unemployment.
Prime Rate in 2022
In November 2021, the inflation rate in the US hit 6.8%. The Fed’s objective is to maintain an average inflation rate of 2% in the long term, so the current inflation rate of 6.8% is much higher than the target inflation rate. Because of this problem, The Fed started discussing the possibility of increasing the overnight rate multiple times during 2022. As of December 2021, the prime rate is 3.25%. The Fed is planning to have 2 to 3 rate hikes, and each rate hike usually refers to a 0.25% increase in the overnight rate.
It is reasonable to expect the prime rate to increase to around 3.75% to 4.25% over the year 2022. Because of those rate hikes, the interest rates on all types of loans will likely go up. This increase in the prime rate will affect asset prices individuals hold as well as prices on various goods and services individuals use. First, stock and house prices may see a downward pressure due to an increase in the interest rates. This means that the individuals who own these types of assets will likely see a decrease in their wealth.
The stock market and housing market are affected by the increase in interest rates, but there are also other factors driving the markets. Even though both markets may decline during 2022, over time they tend to experience recovery and higher growth. Additionally, it might be more troublesome to find an opening during 2022 due to the increased cost of borrowing for all operating businesses. On the other hand, since the inflation rate is likely to decrease as the prime rate increases, consumers can expect slower growth in the prices of different products and services.
There are positive and negative aspects of rate hikes. Given the high inflation the US economy is experiencing, The Federal Reserve is likely to increase rates multiple times during 2022. These hikes should help lower the inflation rate to a manageable level at the cost of lower asset prices and higher unemployment rates.
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