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May 1983, 
Vol. 65, No. 5
Posted 1983-05-01

The Prime Rate and the Cost of Funds: Is the Prime Too High?

by R. W. Hafer

B. W. Hafer investigates the economic forces underlying the prime lending rate. Hafer notes first that, since the early 1970s, the prime rate generally has varied with current credit market conditions: “As the competition for loanable funds and the cost of liability management have increased with the advent of numerous financial innovations, banks have become more sensitive to interest rate changes in establishing their lending rates.” Consequently, prime rate changes accompany changes in banks’ cost of funds. To test this relationship, Hafer examines the effects of movements in the 90-day CD rate and the federal funds rate—measures of a bank’s cost of short-term funds—on the prime rate over the period September 1980 to December 1982. His evidence indicates that a 100-basis-point change in these rates will, after three months, produce a similar change in the prime rate; changes in the prime rate generally follow changes in the cost of funds. To see whether the prime rate currently is too high, given the present cost of funds, Hafer forecasts the prime rate from January through April 1983, using the actual 90-day CD rate and the federal funds rate for the period. The author concludes that “relative to their cost of funds, banks have not kept the prime rate unduly high during the past few months.”