Loading the player...

What is the 'Nominal Interest Rate'

Nominal interest rate refers to the interest rate before taking inflation into account. Nominal can also refer to the advertised or stated interest rate on a loan, without taking into account any fees or compounding of interest. Finally, the federal funds rate, the interest rate set by the Federal Reserve, can also be referred to as a nominal rate.

BREAKING DOWN 'Nominal Interest Rate'

Nominal interest rates exist in contrast to real interest rates and effective interest rates. Real interest rates tend to be important to investors and lenders, while effective rates are significant for borrowers as well as investors and lenders.

Difference Between Nominal and Real Interest Rates

Unlike the nominal rate, the real interest rate takes the inflation rate into account. The equation that links 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 purchasing power erosion through 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 observe the interest rates on Treasury Inflation-Protected Securities (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 3% annual inflation, the investor’s purchasing power erodes by 1% per year.

The Federal Reserve and Nominal Interest Rates

Central banks set short-term nominal interest rates, which form the basis for other interest rates charged by banks and financial institutions. Nominal interest rates may be held at artificially low levels 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 such stimulus measures is that inflation should not be a present or a near-term threat.

Conversely, during inflationary times, central banks tend to set nominal rates high. Unfortunately, they may overestimate the inflation level and keep nominal interest rates too high. The resulting elevated level of interest rates may have serious economic repercussions, as they tend to stall spending.

Difference Between Effective and Nominal Interest Rates

Although the nominal rate is the stated rate associated with a loan, it is typically not the rate that the consumer pays. Rather, the consumer pays an effective rate that varies based on fees and the effect of compounding. To that end, annual percentage rate (APR) differs from the nominal rate, as it takes fees into account, and annual percentage yield (APY) takes both fees and compounding into account.

RELATED TERMS
  1. Nominal

    An unadjusted rate, value or change in value. This type of measure ...
  2. Fisher Effect

    An economic theory proposed by economist Irving Fisher that describes ...
  3. Real Rate Of Return

    The annual percentage return realized on an investment, which ...
  4. Nominal Rate Of Return

    The amount of money generated by an investment before expenses ...
  5. Nominal Yield

    The coupon rate on a bond. The nominal yield is the interest ...
  6. Nominal Value

    The stated value of an issued security. Nominal value in economics ...
Related Articles
  1. Investing

    Interest Rates Explained: Nominal, Real, Effective

    Interest rates are divided into subcategories. Smart investors look beyond the nominal or coupon rate of a bond or loan to see if it fits their objectives.
  2. Investing

    What Does Nominal Mean?

    Nominal refers to an unadjusted value or change in value.
  3. Insights

    Interest Rates: Nominal and Real

    An interest rate is the cost of borrowing money, expressed as a percentage of the loan amount. Interest rates are the primary yardstick for measuring how much return lenders will get. However, ...
  4. Investing

    Understanding the Fisher Effect

    The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate.
  5. Personal Finance

    How Interest Rates Can Go Negative

    Central banks from Europe to Japan have implemented a negative interest rate policy (NIRP) in order to stimulate economic growth.
  6. Insights

    The Taylor Rule: Calculating Monetary Policy

    The Taylor Rule suggests how the central bank should change interest rates to account for inflation and other economic conditions.
  7. Trading

    How Inflation Policy Affects You

    The Fed estimates a long-term goal of 2% inflation for the near future. Learn how that'll impact you.
  8. Investing

    Introduction to Treasury Inflation-Protected Securities (TIPS)

    If you want to protect your portfolio from inflation, all you need are a few TIPS.
  9. Investing

    Explaining Interest Rate Parity

    Interest rate parity exists when the expected nominal rates are the same for both domestic and foreign assets.
  10. Insights

    How Interest Rates Affect The U.S. Markets

    Interest rates can have both positive and negative effects on U.S. stocks, bonds and inflation.
RELATED FAQS
  1. What is the difference between real and nominal interest rates?

    Learn what nominal interest rates and real interest rates are, how real interest rate takes into account the inflation rate, ... Read Answer >>
  2. How do nominal interest rates in finance differ from the nominal rate of interest ...

    Read about the subtle difference between a financial instrument's nominal interest rate of return and the general nominal ... Read Answer >>
  3. How were nominal interest rates in the economy set before the Federal Reserve?

    Learn more about how nominal interest rates are determined, how the Federal Reserve targets them, and how they acted prior ... Read Answer >>
  4. Can real interest rates be negative?

    Discover the circumstances that can cause real interest rates to be negative and learn how to calculate the values of real ... Read Answer >>
  5. If markets give information on value through price, how can nominal values be out ...

    Learn more about nominal values, real values and how these two measurements differ. Explore the impact of inflation and deflation ... Read Answer >>
  6. Under what circumstances is the nominal value out of line with the real value of ...

    Learn more about nominal stock values and market values. Explore causes of differences between nominal and real values for ... Read Answer >>
Hot Definitions
  1. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  2. Down Round

    A round of financing where investors purchase stock from a company at a lower valuation than the valuation placed upon the ...
  3. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  4. Portfolio Investment

    A holding of an asset in a portfolio. A portfolio investment is made with the expectation of earning a return on it. This ...
  5. Treynor Ratio

    A ratio developed by Jack Treynor that measures returns earned in excess of that which could have been earned on a riskless ...
  6. Buyback

    The repurchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market. Companies ...
Trading Center