SOLVING INTEREST RATE MYSTERY LIKE SOLVING MYSTERY NOVEL

This "Financial Focus" column is prepared by Edward Jones Investments, headquartered in St. Louis. Jones includes branches throughout the nation, including Cape Girardeau and Jackson.

Interest rates can be more mysterious than a Stephen King thriller. If the prime rate is 5 percent, why does it cost 10 percent to borrow money?

Cracking the interest rate code starts with understanding two significant short-term rates: the federal funds rate and the prime rate.

Short-term rates are most affected by the federal funds rate. Federal funds are funds, such as those in excess of reserve requirements, deposited by commercial banks at Federal Reserve Banks. On the flip side, banks that don't have enough funds to meet reserve requirements may have to borrow from other banks. They can borrow funds deposited by other banks at Federal Reserve Banks, and the amount of interest they pay is the federal funds rate. These borrowing transactions are done generally overnight.

The federal funds rate is volatile because it's calculated on a day-to-day basis. Economic and technical factors influence its direction. By increasing or decreasing the federal funds target rate, the Fed can orchestrate the flow of money into the economy. A lower federal funds rate makes borrowing more attractive for banks and their customers, thereby, increasing the flow of money into the economy. A higher federal funds rate tightens the flow. These moves by the Fed are generally cautious, avoiding knee-jerk reactions to breaking news of the economy. The federal funds rate is the benchmark for pricing other short-term securities.

The more widely publicized prime rate is the interest rate banks charge to their most credit-worthy customers, typically only blue chip corporations. Rates on loans to less credit-worthy customers (which generally include most individuals and businesses) are tied to prime rate.

Prime rate is determined by the market forces affecting a bank's cost of funds and the rates borrowers will accept. Because Fed funds are the source of funds to a bank, the prime rate set by a bank must be higher than the federal funds rate the bank pays. The difference, or spread, reflects the amount of risk the bank is willing to take in assuming a customer loan, plus a reasonable profit for the bank and its shareholders. When the Federal Reserve raises or lowers its rates, the prime rate follows.

The next time you're mystified by rates on short-term securities, remember these two clues: prime rate and federal funds rate.

The Southeast Missourian does not recommend that readers buy or sell stocks featured in this column, which is provided for informational purposes only.