Federal Funds Rate Vs. Prime Rate

The Federal Funds Target Rate -- federal funds or fed funds rate -- and the prime rate are closely linked. The fed funds rate is the rate at which banks can borrow money and the prime rate is the base rate at which banks lend money. Both rates are used as base or index rates for different types of investments and loans.

Identification

• The federal funds rate is set by the Federal Open Market Committee -- FOMC -- of the U.S. Federal Reserve Board. The fed funds rate is the rate at which banks borrow from each other and the Federal Reserve. The rate acts as the base rate for all short-term interest rates for investing or borrowing. The prime rate is the index rate used by banks to set consumer and commercial lending rates.

Function

• Since 1994, the national prime rate has been set at the federal funds rate plus three percent, according to The Wall Street Journal. Whenever the FOMC changes the target for the federal funds rate, the prime rate is immediately adjusted by the same amount. If the FOMC raises the fed funds rate by one-quarter of a percent, the prime rate will increase by one-quarter of one percent.

Time Frame

• The FOMC meets every six weeks, or about eight times a year. The committee announces any changes to the federal funds target rate immediately following the meeting. The announcement is in the early afternoon of the meeting date. The prime rate is adjusted immediately if a change to the federal funds rate is announced.

Significance

• The federal funds rate is used by the Federal Reserve to even out the cycles of the U.S. economy. The rate will be increased to slow a rapidly expanding economy and reduce the possibility of high inflation. The rate will be lowered when the economy is slowing or in a recession. The prime rate will rise or fall at the same time, affecting the borrowing costs of companies and individuals. Credit card and home equity line of credit rates are two types of consumer lending that have their rates tied to the prime rate.

History

• In December 2008, the FOMC made a historic move by lowering the federal funds rate from 1.0 percent to a target of zero to 0.25 percent. This is essentially a zero percent fed funds rate. At the same time, the prime rate dropped to 3.25 percent. Through October 2010, the FOMC had not changed the federal funds rate and the prime rate had not changed. Typically, the FOMC will change the federal funds rate in quarter-percent increments.