The prime rate is an important interest rate that banks use to set rates for loans. The prime rate acts as a benchmark for many short-term interest rates, so when it rises, so do borrowing costs for consumers and businesses. Let’s take a look at the history of the prime rate and find out how high it has gone over time.
What Is the Prime Rate?
The prime rate is the interest rate that commercial banks charge their most creditworthy corporate customers. It is often used as a reference rate for short-term business loans, credit cards, auto loans, and adjustable-rate mortgages. The prime rate adjusts as economic conditions change and is influenced by the federal funds rate, which is the interest rate banks charge each other for overnight lending.
Although each bank sets its own prime rate, most base it on the prime rate published in The Wall Street Journal. The Journal surveys large U.S. banks and publishes the consensus prime rate. This stated prime rate serves as a benchmark that affects borrowing costs throughout the economy.
History of Prime Rate Changes
The prime rate steadily increased during the 1970s and early 1980s along with high inflation. It peaked at 21.5% in December 1980. Since then, it has gradually declined to low single digits.
Here is a timeline showing key prime rate changes over the decades:
- 1960s – The prime rate was about 4-6%
- 1970s – The prime rate rose from 7.75% in 1973 to 12.25% in 1976 as inflation increased.
- Early 1980s – The prime rate surged to unprecedented levels, reaching 20.5% in April 1980 and peaking at 21.5% in December 1980 as the Federal Reserve aggressively fought inflation.
- Mid 1980s – The prime rate fell back to single digits, declining to 9.5% in 1985 and 8.75% in 1987.
- 1990s – Rates continued to decrease in the 1990s, ending the decade at 8.5% in 1999.
- 2000s – The prime rate dropped steadily, ending the decade at 3.25% in 2009.
- 2010s – The prime rate hovered between 3-5% for most of the 2010s before ending the decade at 4.75%.
- Today – As of November 2022, the prime rate stands at 7%, after the Federal Reserve raised rates to fight inflation.
The highest prime rate on record is 21.5%, reached in December 1980 during the early 1980s recession when the Federal Reserve was aggressively raising interest rates to curb runaway inflation.
Causes of the High Prime Rate in the 1980s
The unprecedented spike in the prime rate to over 20% in 1980 was fueled by several economic factors:
- High inflation – Inflation rose dramatically in the late 1970s and early 1980s. It peaked at 14.8% in March 1980 as energy prices soared. High inflation led the Federal Reserve to aggressively raise interest rates.
- Restrictive monetary policy – To curb inflation, the Fed under Chairman Paul Volcker pursued a tight monetary policy, severely restricting the money supply and causing interest rates to skyrocket.
- Federal funds rate hikes – The Federal Reserve raised the federal funds rate, which directly influences the prime rate banks charge. The fed funds rate hit 20% in 1980.
- Recession – The economic policies intended to reduce inflation contributed to an economic recession from January to July 1980 and a more severe recession from 1981-1982.
In essence, high inflation triggered restrictive Fed policy aimed at increasing borrowing costs to reduce economic activity and control prices. This combination resulted in the highest prime rate on record.
Impacts of the High Prime Rate
The prime rate over 20% had significant impacts on consumers and businesses:
- For consumers, interest costs soared for credit cards, auto loans, and adjustable-rate mortgages tied to the prime rate. Housing affordability declined as mortgage rates spiked above 18%.
- For businesses, borrowing and expanding became very expensive. High interest costs made it harder to operate profitably.
- High rates contributed to slower economic growth and rising unemployment as business activity declined.
- The strong economic medicine of high rates did successfully curb inflation, bringing it down significantly by 1983.
The extraordinarily high prime rate caused a great deal of economic pain for many households and businesses. However, it did achieve the Fed’s goal of wringing high inflation out of the economy, paving the way for more stable growth in the 1980s and beyond. The severe conditions of 1980 likely discouraged the Fed from pursuing such restrictive policies again.
Prime Rate Changes Since 1980
Since hitting its peak in 1980, the prime rate has steadily declined over the past four decades:
- In the 1980s, the prime rate fell from around 20% to around 10% by the end of the decade.
- In the 1990s, rates declined further to around 8% as inflation remained modest.
- In the 2000s, the prime rate dropped below 5% as the Fed sought to boost the economy.
- In the 2010s, the prime rate hovered between 3-5% following the Great Recession.
- In 2022, the prime rate has increased rapidly from 3.25% to 7% as the Fed battles high inflation.
The prime rate has remained below 10% over the past 30+ years after the extraordinary conditions of the early 1980s subsided. Going forward, it will likely climb further in the near term as the Fed combats inflation by tightening monetary policy.
Reasons for Declining Prime Rate Since 1980
Why has the prime rate remained so much lower since the early 1980s? There are a few key reasons:
- The Federal Reserve has pursued less restrictive monetary policy and has not targeted 20% interest rates again.
- Inflation has been relatively stable, other than a few temporary spikes.
- Economic growth has been steady but slower compared to the 1950s-1960s.
- The Fed has been quicker to cut rates to stimulate growth during recessions.
- Global factors and the rise of automation have helped dampen inflation pressures.
Essentially, the economic volatility and high inflation of the 1970s has not been repeated. While inflation has ticked up recently, it remains below the dramatic levels of 1980. This has allowed the prime rate to stabilize at single digit levels for most of the past four decades.
Outlook for the Prime Rate
The prime rate has risen swiftly in 2022 as the Federal Reserve bumps up the federal funds rate to combat high inflation. Further prime rate hikes are likely in 2023 as the Fed maintains its aggressive stance against inflation.
Many economists expect the prime rate to peak around 7-8% in 2023 before gradually dropping back down. However, the outlook remains uncertain.
Key factors that will influence the prime rate going forward:
- How persistent inflation proves to be and when it will recede to the Fed’s 2% target.
- How high the Fed ultimately raises the federal funds rate.
- Whether the economy cools enough to avoid a severe recession that requires rate cuts.
- Global factors like energy prices, supply chain issues, and foreign central bank policies.
While the prime rate is expected to remain elevated in 2023, it likely will not return to the double-digit levels of the early 1980s. The Federal Reserve wants to avoid restrictive policies that could severely undermine the economy. Still, the path of inflation and economic growth warrants close monitoring to foresee prime rate changes.
Conclusion
In summary, the highest the prime rate has been was 21.5% in December 1980. This extreme spike was fueled by runaway inflation, restrictive Fed policy, and recession. The impossibly high cost of borrowing caused significant economic damage. However, it did tame inflation after which the prime rate began a four-decade decline to low single digits.
Economists do not expect the prime rate to reach 1980s levels again soon given the Federal Reserve’s current policies. However, the prime rate may rise above 7% in 2023 before falling back by 2024 if inflation moderates. The prime rate’s path forward will depend on how inflation and monetary policy evolve. But for now, the era of 20% prime rates remains confined to history books.
