What is the nominal interest rate?
The nominal interest rate refers to the interest rate before taking inflation into account. The nominal may also refer to the interest rate announced or declared on a loan, without taking into account the costs or the composition of interest. The nominal interest rate formula can be calculated as follows: r = m ×[(1+i)[(1+i)[(1+i)[(1+i)1 / m – 1].
i = the effective rate
r = the rate indicated
m = the number of composition periods
Finally, the federal funds rate, the interest rate set by the Federal Reserve, can also be called the nominal rate.
Interest rates: nominal and real
Understanding the nominal interest rate
Nominal interest rates exist unlike real and effective interest rates. Real interest rates tend to be important for investors and lenders, while effective rates are important for borrowers as well as investors and lenders.
Difference between nominal and real interest rates
Unlike the nominal rate, the real interest rate takes into account the inflation rate. The equation linking nominal and real interest rates can be approximated as nominal rate = real interest rate + inflation rate, or nominal rate – inflation rate = real rate.
To avoid the erosion of purchasing power by inflation, investors consider the real interest rate rather than the nominal rate. One way to estimate the real rate of return in the United States is to look at the interest rates on inflation-protected Treasury bills (TIPS). The difference between the yield on a Treasury bond and the yield on TIPS of the same maturity provides an estimate of inflation expectations in the economy.
For example, if the nominal interest rate offered on a three-year deposit is 4% and the inflation rate over this period is 3%, the investor’s real rate of return is 1%. On the other hand, if the nominal interest rate is 2% in an environment of annual inflation of 3%, the purchasing power of the investor is eroded by 1% per year.
The Federal Reserve and nominal interest rates
Central banks set nominal short-term interest rates, which form the basis for other interest rates charged by banks and financial institutions. Nominal interest rates can be kept artificially low after a major recession to stimulate economic activity through low real interest rates, which encourage consumers to take out loans and spend money. However, a necessary condition for these stimulus measures is that inflation is not a present or short-term threat.
Conversely, in times of inflation, central banks tend to set high nominal rates. Unfortunately, they can overestimate the level of inflation and keep nominal interest rates too high. The resulting high interest rates can have serious economic repercussions, as they tend to block spending.
Difference between effective and nominal interest rates
Although the nominal rate is the declared rate associated with a loan, it is generally not the rate that the consumer pays. The consumer rather pays an effective rate which varies according to the costs and the effect of the composition. To this end, the annual percentage rate (APR) differs from the nominal rate in that it takes account of costs, and the annual percentage return (APY) takes into account both costs and composition.