Nonrandom behavior of the prime rate of interest

Abstract

If the banking industry's structure is noncompetitive, then an ideal pricing strategy for the prime rate of interest would be a ratchet type mechanism where the prime rises more rapidly in periods of increasing interest rates and falls more slowly during periods of declining rates. The purpose of this paper is to present evidence of such asymmetric behavior of the prime when it is compared to a more dynamic ra te-the one month CD rate. Initially, monthly data were collected for both the prime and CD rates from January 1968 through December 1982, a period which covers a broad spectrum of Federal Reserve policies toward its member banks. The definition used for interest rate direction is based upon the one month trend in the CD rate. A runs test about the median was performed on the difference between the prime and CD rates to test if this statistic is nonrandom and a Z score of -9 .9047 was obtained. This statistic leads one to conclude that the behavior of the statistic (prime-CD) is in fact not random. The mean of the statistic (prime-CD) was calculated for periods of increasing and decreasing rates. During periods of rising rates, the average spread was 1.058 percent; when rates decreased, this spread increased to 1.848 percent. The difference between these two means is significant at the .01 level. Finally, an econometric model of the form: