What is the relationship between the nominal interest rate and the annual percentage?

The nominal interest rate is composed of the real interest rate plus a premium for inflation expectations. The nominal interest rate is not adjusted for true inflation, and is quoted on many financial products such as loans or savings accounts.

Definition and Examples of the Nominal Interest Rate

Nominal interest rates are based on inflation expectations and actual inflation reported, as well as the real interest rate. Financial institutions set nominal interest rates for loans and savings accounts to ensure that they will earn, rather than lose, money in their product offerings. As a result, nominal interest rates change as often as weekly or daily.

It is important to understand the nominal interest rate when you use products and services from financial institutions, as it will state the amount of interest you will pay to borrow money, or the amount you will earn on a savings account.

In mathematical terms, the formula would look like this:

Nominal interest rate = Real interest rate + Inflation expectations

One example of a nominal interest rate is an interest rate quoted at a bank on any given day.  If a bank advertises an annual interest rate of 2.59% on a car loan, this is the nominal interest rate. It is the amount of interest a person would pay in a year for borrowing funds to buy a car.

How Does the Nominal Interest Rate Work?

A financial institution will look to a number of sources to set its own nominal interest rate. These include the Federal Reserve, competitors’ pricing, and its own costs of doing business and lending money.

The federal funds rate is the interest rate banks charge one another overnight for funds. The Federal Reserve raises the federal funds rate to slow demand for borrowing funds and decrease inflation, and lowers the federal funds rate to encourage borrowing. Changes in the federal funds rate will affect financial institutions’ costs of doing business, and this will be reflected in the interest rates financial institutions charge on their loans and pay on their savings accounts.

Note

Another way financial institutions get a sense of current inflation and future inflation is by looking at the Consumer Price Index (CPI). It is a widely used measure of inflation, and can be used to track the prices of a market basket of goods and services over time.

When setting the nominal interest rate on loans, a financial institution does not want to charge too high of a rate compared to its competitors. At the same time, a financial institution must understand its own cost structure because this impacts what its real interest needs to be to be profitable as a financial institution. A similar analysis is made by financial institutions when considering what interest to pay on savings accounts.

Parts of the Nominal Interest Rate

The nominal interest rate is partly composed of the real interest rate, which is what a bank charges to cover costs and make profit. For example, the money a bank earns from the real interest rate represents what it needs to pay for expenses such as labor, physical buildings, cost of products, etc.

Note

Since lending money always involves risk on the part of the bank, the real interest rate on a loan also represents a bank’s opportunity cost of lending out that money.

The other component of the nominal interest rate is inflation expectations. A bank will add in a certain percentage based on what it expects inflation to be over a given period, so the real purchasing power of the money it lent out does not lose value over time. If inflation is expected to be 5% in a year, and a bank needs to earn a 3% real interest rate, then the nominal interest rate for a one-year loan would be 8%. If a bank only charged 3% and did not account for inflation expectations, then when the loan plus interest is repaid, the bank would be worse off.

How Do Banks Determine Expected Inflation?

United States Treasury securities provide an easy way to see what expected inflation is over time. You can compare yields on Treasury securities that have a similar maturity date, where one type of security is adjusted for inflation, while the other is not. For example, a Treasury Inflation-Protected Security (TIPS) will pay investors an inflation-adjusted principal amount plus a fixed interest rate, which represents the real interest rate.

Since this security is adjusted for inflation, the fixed interest rate represents the real interest rate on a Treasury security for a set amount of time. A Treasury Bond (T-bond), on the other hand, does not adjust for inflation.  Taking the difference in yields between a T-bond and a TIPS security, with the same maturity date, will show what expected inflation is over that time period.

Key Takeaways

• The nominal interest rate is the interest rate quoted on savings accounts and bank loans.
• The nominal interest rate is made up of the real interest rate plus inflation expectations.
• The real interest rate represents the opportunity cost of lending money out.
• Inflation expectations can be found by comparing the difference in yields between Treasury bonds and TIPS.

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