Nominal Interest Rate

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 What is the Nominal Interest Rate?

The nominal interest rate refers to the rate of interest before adjusting for inflation. It also refers to the rate specified in the loan contract without adjusting for compounding. The nominal interest rate is in contrast to the real interest rate regarding the inflation adjustment and effective interest rate regarding the compounding adjustment.

Nominal interest rates can be impacted by different factors, including the demand and supply of money, the action of the federal government, the monetary policy of the central bank, and many others.

Central banks implement the short-term nominal interest rate as a tool of monetary policy. During an economic recession, the nominal rate is lowered to stimulate economic activities. During inflationary periods, the nominal rate is raised.

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.1 However, a necessary condition for such stimulus measures is that inflation should not be a present or a near-term threat. In the United States, the federal funds rate, the interest rate set by the Federal Reserve, can also be referred to as a nominal rate.

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.

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.

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.

Inflation Adjustment of Nominal Interest Rate:

The Fisher Effect describes the relationship between inflation and nominal or real interest rate through the equation below:
(1 + i) = (1 + R) (1 + h)

Where:
i – Nominal interest rate
R – Real interest rate
h – Expected inflation rate

In a stable economy that is growing at a moderate pace, the inflation rate is usually low. With a low inflation rate, a simplified version of the Fisher equation can be implemented. It states that the nominal interest rate is approximately equal to the real interest rate plus the inflation rate (i = R + h).

For example, a bond investor is expecting a real interest rate of 5%, when the market shows an expected inflation rate of 3%. Therefore, the investor should look for a bond with a stated (nominal) interest rate of 8% (5% + 3%).

The nominal interest rate can also be calculated through the formula below. The two methods of calculation give a similar result:
                 
 i = (1 + R) (1 + h) – 1 = (1 + 5%) (1 + 3%) – 1 = 8.15%

According to the Fisher Effect, if the inflation rate increases and the nominal interest rate remains constant, the real interest rate will fall. 

The lender’s real return drops as a result of a faster decline in the purchasing power. If the nominal interest rate and expected inflation rate both increase at the same rate, which means the inflation premium is compensated, the real interest will remain unchanged.

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