The ordinary people and the prime rate of interest

The Bank of Ghana, through its Monetary Policy Committee (MPC), last Monday March 17, increased the prime interest rate by 0.75 percentage point from 13.50 percent to 14.25 percent. This became necessary as, according to the Bank, all economic indications justify their decision.

The decision has many implications on the Ghanaian economy, especially when elections are looming and every political party is trying to out-do the other on the economic front.

By the lame man’s definition, the prime rate of interest is the basic interest rate that banks charge their loyal customers or least financial risky customers. It is thus the base rate (index) from which all other interest rates pertaining to the various sectors are derived for lending.

Very often, it is considered to be a lagging indicator in that its adjustments occur only when changes have already occurred in the over-all economy. Its importance is its ability to confirm that a pattern or trend is occurring or about to occur. It also informs financial customers about the minimum debt service rate they are expected to pay should they decide to take any funds for their investment activities.

Further still, knowing this information gives borrowers reasonable knowledge to effectively negotiate terms and conditions with lenders; and with this they will be able to access the best going deal on the financial market for their investments.

In exceptional cases for high-risk borrowers, most loans are indexed to the prime rate. Hence, in our Ghanaian case in which increases at every level of our economy automatically translate into increases in associated variables, it will be naïve for any one to think that the banks will not increase their banking rates for the various sectors.

Central banks do not just determine the prime rate for determining sake. They take wide ranging indexes into consideration with the view that the impacts on the economy will not throw economic activities out of gear. Adjustments in prime interest rate, most often, impact the stock (equity) market with trading, ultimately affecting the entire economic setting at any given period. Hence, it is the responsibility of every Central Bank to monitor the economy and adjusts the rates to ensure that stability is well established in volatile markets.

In the case of the decision by the Bank of Ghana to peg the prime rate from 13.50 percent to 14.25 percent, the bank noted such issues as the changes in the commodity prices, sharp re-alignment of international currency exchanges, high food inflation and the escalating crude oil prices, increases in budget deficit, trends in both revenue and expenditure of the government concerning the 2008 budget, easing of credit conditions by the banks, effects of utility price hiking in recent times, etc. etc. constituted the bedrock upon which the decision was taken.

Irrespective of the effects of this increment, the Bank of Ghana’s main motive is to tune monetary policies so that “expectations remain anchored to stability and consistent with a process of disinflation to secure the environment for steady expansion of output.”

So what do we expect as a result of this increment?

In a normal economic setting, ordinary people will never be offered the current prime interest rate as it is only a rate offered by the financial institutions to their very good customers. Since banks borrow money to lend their individual customers; and smaller banks borrow from bigger ones at a cost, certainly small banks borrow from larger banks at rates higher than the current prime interest rate and those banks might borrow from even larger companies.

This chain of borrowing and lending comes at additional cost, which ultimately must be borne by the final customer. That is why for instance when the prime rate was 13.50 percent the lending rates for all the banking institutions were ranging between 28.9 percent and 35 percent. So with this hike in the prime rate by 0.75 percent it is obvious that most banks will also increase their lending rate to their normal customers.

What the 14.25 percent prime rate then means is that for every Gh¢100 borrowed, there is an element of cost amounting to Gh¢14.25 bringing the total investment cost at the end of the year to Gh¢114.25. This will exclude the component charged by the individual banks depending on the services and terms of conditions available for the facility.

By deduction, consumption cost as a whole will hike up in the medium to long term. However, some economists are of the view that consumption at times is insensitive to changes in interest rate necessitated by changes in prime rate of interest. This is because no one will significantly reduce the purchases of goods and services needed just because of an increase in the prime rate.

In terms of wealth effects, a down change in the prime rate of interest increases the value of long-term financial stocks (equities), and the value of such products like real assets (houses) will also increase. Providers (owners) of such investments will increase their consumption of the created wealth and hence increase overall consumption.

However, an increase in the prime rate will increase the cost of investments leading to a decrease in the employment of resources for production. The effect is that consumption will fall and the economy may stagnate or worse still will decline.

In conclusion, prime rate changes affect the ordinary people positively and negatively through the overall consumption and investment process. It therefore behoves on the central bank to ensure that such effects do not destabilise the entire economic process.

Views expressed by the author(s) do not necessarily reflect those of GhanaHomePage.