Nominal interest rate

What Is Nominal Interest Rate?

The nominal interest rate is the stated rate of interest on a loan or investment, unadjusted for inflation. It represents the absolute return a lender receives or the absolute cost a borrower pays over a specific period. This fundamental concept falls under macroeconomic finance and is crucial for understanding how money grows or shrinks over time. Unlike the real interest rate, the nominal interest rate does not reflect the true purchasing power of the money involved, as it does not account for changes in the price level. It is the rate one typically sees advertised by banks for savings accounts, mortgages, or other loans.

History and Origin

The concept of interest rates dates back to ancient civilizations, with evidence of lending and borrowing practices in Babylon around 2000 BC, where the Code of Hammurabi regulated interest rates. Throughout history, interest rates have been influenced by economic conditions, the scarcity of capital, and prevailing societal views on lending. During the Middle Ages, the charging of interest was often prohibited by the Catholic Church; however, various alternative forms of compensation for loans emerged. The modern understanding and widespread recording of official interest rates began with the establishment of central banks, such as the Bank of England in 1694. In the United States, interest rates were highly variable in the colonial era, and it wasn't until the establishment of the Federal Reserve System in 1913 that the U.S. had a permanent central bank playing a significant role in influencing rates⁶. Historically, the level of interest rates has often mirrored periods of economic growth and contraction. For instance, during the Great Depression in the 1930s, interest rates declined significantly as profit opportunities dried up, while periods of high inflation, such as the 1970s, saw nominal interest rates rise sharply⁵.

Key Takeaways

• The nominal interest rate is the quoted interest rate without accounting for inflation.
• It represents the monetary return on an investment or the monetary cost of a loan.
• Central banks actively manage nominal interest rates as a tool for monetary policy.
• The actual return or cost, considering inflation, is reflected by the real interest rate.
• Understanding the nominal interest rate is crucial for evaluating financial products and economic conditions.

Formula and Calculation

The nominal interest rate is typically the advertised rate. However, its relationship with the real interest rate and inflation is often expressed through the Fisher Equation. While the nominal rate itself doesn't require a calculation based on other variables to be stated, the real interest rate is derived from it. The relationship is as follows:

Conversely, to find the real interest rate, one would use:

Where:

• Nominal Interest Rate is the stated rate.
• Real Interest Rate is the interest rate adjusted for inflation.
• Inflation Rate is the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling.

This approximation is commonly used, though a more precise formula exists. The Consumer Price Index (Consumer Price Index) is a widely used measure for calculating the inflation rate⁴.

Interpreting the Nominal Interest Rate

The nominal interest rate is the most straightforward figure when discussing lending and borrowing. For borrowers, it represents the total percentage of the principal they will pay back annually in addition to the principal itself. For savers and investors, it indicates the percentage return they will receive on their capital.

However, interpreting the nominal interest rate in isolation can be misleading. A high nominal interest rate might seem attractive to a saver, but if the inflation rate is higher, the actual return on their money (the real return) would be negative, meaning their purchasing power has decreased. Conversely, a low nominal interest rate might appear cheap for borrowers, but if deflation occurs, the real cost of borrowing could be significantly higher than the nominal rate. Therefore, to truly understand the economic impact of a nominal interest rate, it must be considered alongside the prevailing inflation rate to determine the real interest rate. This distinction is fundamental to sound investment decisions.

Hypothetical Example

Consider a saver who deposits $1,000 into a savings accounts offering a 5% annual nominal interest rate. After one year, their account balance will grow to $1,050.

Now, let's introduce inflation. Suppose the inflation rate over that same year is 3%. While the saver's nominal balance increased by $50, the prices of goods and services also increased by 3%.

To understand the real gain, we would use the Fisher Effect. The real interest rate received would be approximately:

This means that, after accounting for the loss of purchasing power due to inflation, the saver's money can actually buy 2% more goods and services than it could a year ago. If the nominal interest rate had been 2% and inflation 3%, the real return would be -1%, indicating a loss of purchasing power.

Practical Applications

The nominal interest rate is a ubiquitous figure in financial markets and daily economic life:

• Lending and Borrowing: When consumers take out mortgages, car loans, or use credit cards, the advertised rate is the nominal interest rate. Businesses also face nominal borrowing costs for their operations and investments.
• Central Bank Policy: Central banks, such as the U.S. Federal Reserve, primarily target short-term nominal interest rates (like the federal funds rate) as a key component of their monetary policy. By adjusting this rate, they influence overall economic activity, credit availability, and inflation³.
• Bond Markets: The yield-to-maturity quoted for bonds is a nominal interest rate, reflecting the total return an investor expects to receive if they hold the bond until maturity, without adjusting for inflation. These bond yields are a crucial indicator of market expectations.
• Financial Product Comparisons: When comparing different financial products like certificates of deposit (CDs) or savings accounts, the nominal interest rate is the direct comparison point for the stated return.
• International Finance: Nominal interest rate differentials between countries can influence capital flows and foreign exchange rates, as investors seek higher nominal returns, though they must also consider inflation and currency risk.
• Inflation Targeting: Central banks often communicate their nominal interest rate adjustments in the context of their inflation targets. For example, during periods of desired disinflation, nominal interest rates may be uniformly lowered in line with expectations of lower future inflation, even if real interest rates remain largely unchanged².

Limitations and Criticisms

While essential, relying solely on the nominal interest rate has limitations:

• Inflation Blindness: The primary criticism is its failure to account for inflation. A high nominal rate can still lead to a negative real return if inflation is sufficiently high, eroding purchasing power. This makes it an incomplete measure of the true cost of borrowing or the true return on investment.
• Misleading Comparisons: Without considering inflation, comparing nominal interest rates across different time periods or economies with varying inflation environments can be misleading. A 5% nominal rate in an economy with 2% inflation is economically different from a 5% nominal rate in an economy with 7% inflation.
• Impact on Savings: For savers, a low nominal interest rate combined with even moderate inflation can severely diminish the real value of their savings over time, discouraging long-term financial planning.
• Distortion of Economic Signals: If monetary policy focuses too heavily on nominal rates without sufficient consideration for real rates and inflation expectations, it can inadvertently stimulate or contract the economy more than intended.
• Difficulty in Forecasting: The forward-looking real interest rate, which is theoretically what matters for investment and consumption decisions, is unobservable and depends on expected inflation. While nominal rates are observed, the underlying real rate and inflation expectations can be difficult to discern or forecast, leading to potential misinterpretations of policy effects¹.

Nominal Interest Rate vs. Real Interest Rate

The terms "nominal interest rate" and "real interest rate" are frequently confused but represent distinct concepts fundamental to macroeconomic finance.

The key point of confusion often arises because the nominal rate is what is immediately visible. However, for any long-term financial decision or economic analysis, the real interest rate provides a more accurate picture of the economic reality by factoring in the erosion or enhancement of money's value due to inflation.

FAQs

Q: Why do central banks focus on the nominal interest rate?
A: Central banks primarily target short-term nominal interest rates, like the federal funds rate in the U.S., because they have direct control over these rates through their monetary policy tools. By adjusting the nominal rate, they aim to influence other interest rates throughout the economy, thereby affecting borrowing, lending, and overall economic activity and inflation.

Q: Can the nominal interest rate be negative?
A: Yes, in some instances, particularly in certain developed economies and during periods of extreme economic stimulus, central banks have set nominal interest rates below zero. This means that depositors might essentially pay banks to hold their money, or lenders receive back slightly less than they lent in nominal terms. However, negative nominal rates are rare for consumer products like savings accounts.

Q: How does the nominal interest rate affect my mortgage payments?
A: The nominal interest rate is the basis for calculating your mortgage payments. A higher nominal rate means higher monthly payments and a greater total cost of the loan over its term, assuming all other factors remain constant. While you pay the nominal rate, the real cost of your mortgage is also affected by inflation over the life of the loan.