NEW YORK -- Citibank, Chase Manhattan, Chemical and a host of other banks increased their prime rate yesterday to 6.25 percent from 6 percent after the Federal Reserve's decision Tuesday to increase short-term interest rates to fend off inflation.
The prime rate increase will mean higher interest rates for millions of consumers and businesses, since the rates on many home mortgages, credit cards and small business loans are linked to the prime.
It is the first increase in the prime since February 1989, when it was raised to 11.5 percent. Most banks have had their prime rates set at 6 percent since July 1992.
Bankers said the increase in the prime was a natural consequence of the increase in the interest rate on federal funds, the name for overnight loans between banks, to 3.5 percent from 3.25 percent Tuesday.
The federal funds rate is set in an open market, but it is heavily influenced by the trading activity of the Federal Reserve.
"This is what the Fed wanted," said Arjun K. Mathrani, the treasurer of the Chase Manhattan Bank. "If the federal funds rate went up, but not the prime, it wouldn't have the inflation-fighting effect the Fed expects."
He noted that interest rates had remained low for almost two years and that banks had reduced the rates they set for certain types of borrowing.
"The consumer has benefited dramatically over the last 18 to 24 months as rates declined and banks reduced their rates, especial ly on credit cards," Mr. Mathrani said.
The lower interest rates have helped to stimulate the economy by reducing the borrowing costs for many consumers and businesses. But as the pace of the economy picked up, long-term interest rates began to rise, reflecting investors' expectations that inflation would increase.
Long-term rates jumped by more than a percentage point from their lows of last fall.
The Fed has been trying to keep a lid on inflation expectations by showing that it is ready to slow growth by raising short-term rates. On Feb. 4, it moved short rates up by a quarter of a percentage point, and then took another quarter-point step this week.
Traditionally, the prime rate was the interest rate paid by the highest-quality corporate borrowers, but over the last 15 years these companies have found ways to borrow money at rates far lower than prime.
Over the same period, more consumer loans have been made with variable interest rates, and many of those loans are set with interest rates that rise and fall with the prime.
For example, Citicorp, the nation's largest bank, has $20 billion in loans based on the prime rate, and most of those are credit cards.
Citicorp's standard credit card carries an interest rate of the prime rate plus 9.4 points. Thus the rate paid by holders of those cards will increase to 15.65 from 15.4 percent.
Small and medium-size businesses also borrow money at rates that are tied to prime.
While borrowing by consumers and business has picked up smartly in recent months, bankers were still worried that an increase in rates would stifle loan demand, and had held back in lifting the prime.
And the same concerns led bankers to raise rates by only one-quarter of a percentage point yesterday, rather than the one-half a percentage point that the federal funds rate has increased since February.
"The reason we only went up 25 basis points was we were concerned that a 50-basis-point jump might slow down what had been some pretty good loan demand," said Richard M. Kovacevich, chief executive of Norwest Corp., based in Minneapolis. A basis point is one hundredth of a percentage point. "A 50-basis-point increase was justified," he said.
Mr. Kovacevich predicted that banks would try to raise the prime again in several months -- perhaps jumping to 6.75 percent -- if the Fed raises the fed funds rate by another quarter point.
While the prime rate is set by individual banks and changed only occasionally, other interest rates which are subject to daily market forces have risen sharply since the Fed's first move in February.
Rates on new fixed-rate mortgage loans, for example, are already at the highest level in a year, at an average of 7.76 percent last week, according to the Federal Home Loan Mortgage Corp.
Bankers noted with interest that it was Norwest and then Bank One Corp. of Columbus, Ohio, two of the newly emerging big regional banking companies, rather than big New York banks, that first announced the rate increase.
"The fact that the regional banks moved first reflects the fact that the prime is now much more of a consumer and small-business rate than a wholesale lending rate," said Mr. Mathrani of Chase, which waited until the end of the day to announce its change.