Nominal Interest Rate

A nominal interest rate is the interest rate stated on a loan, deposit or bond before any adjustment for inflation. It is the rate written in the contract or quoted by a bank: a mortgage at 6%, a fixed deposit at 4%, a central bank's policy rate at 3.5%. Because it measures the growth of money balances, not of purchasing power, it can differ greatly from the real interest rate, which subtracts expected or actual inflation.

Almost every rate seen in daily life is nominal, including the federal funds rate, the Bank of England's Bank Rate and the ECB's deposit facility rate. The link between nominal rates, real rates and inflation is described by the Fisher equation, named after Irving Fisher, and is central to monetary policy, bond pricing and savings decisions. The broader topic is covered under interest rates.

If you lend a friend 100 and they promise to pay back 105 next year, the nominal interest rate is 5%: you get five more units of money. But whether you are really better off depends on prices. If everything in the shops costs 5% more by then, the 105 buys exactly what 100 bought before, and your real gain is zero.

The nominal rate is the number on the label. The real rate is what that number is worth once you account for prices changing. Banks, newspapers and loan agreements nearly always quote the label; savers and borrowers have to do the second step themselves to know whether money is growing or shrinking in practice.

The exact relationship between nominal and real rates is:

• $i$ is the nominal interest rate.
• $r$ is the real interest rate.
• $\pi^{e}$ is expected inflation over the life of the loan.

For low rates this is usually approximated as $i \approx r + \pi^{e}$. Worked example: if lenders want a real return of 2% and expect 3% inflation, they will ask a nominal rate of about 5%; the exact figure is $1.02 \times 1.03 - 1 = 5.06\%$. If inflation then turns out to be 6%, the realised real return is roughly $5\% - 6\% = -1\%$, and wealth shifts from the creditor to the borrower.

The "Fisher effect" is the prediction that, over time, nominal rates move roughly one-for-one with expected inflation, leaving real rates broadly unchanged. Countries with persistently high inflation, such as Argentina and Turkey in recent years, have correspondingly high nominal rates.

• Central-bank policy. Central banks set a short-term policy rate and steer market rates through open market operations and the rate they pay on bank reserves; see interest on reserves. Policy-rate decisions are often guided by rules of thumb such as the Taylor rule.
• Expected inflation. Lenders build expected price rises into the rate, which is why credible inflation targeting tends to lower long-term rates.
• Term and risk premiums. Longer maturities and riskier borrowers usually pay more; the pattern across maturities is shown by the yield curve and the extra charge for default risk by the risk premium.
• Supply and demand for saving. Global saving, investment demand and demographics shape the neutral interest rate (r-star) around which policy rates move.

Nominal rates cannot fall far below zero, because people could withdraw cash, which pays a nominal rate of zero. This floor, the zero lower bound (ZLB), limits how much a central bank can cut during a slump or deflation. Several central banks, including the ECB, the Swiss National Bank and the Bank of Japan, set slightly negative interest rates in the 2010s, showing that the effective floor is a little below zero. When the floor binds, real rates can stay too high even with nominal rates at zero, which is why central banks turned to quantitative easing (QE) and forward guidance.

Quoted rates come in several forms. Loans and deposits may state an annual percentage rate (APR), which ignores compounding within the year, or an annual percentage yield (APY), which includes it. A rate can be a fixed interest rate for the whole term or a floating rate reset against a benchmark such as SOFR in the United States, €STR in the euro area or KIBOR in Pakistan. In Islamic finance, where interest is prohibited, profit rates on financing are often benchmarked against the same nominal reference rates.

For households, the key lesson is that a high nominal rate is not necessarily good for savers or bad for borrowers; what matters is the rate after inflation, discussed under real terms. Ignoring that difference is a classic form of money illusion.

• Federal Reserve: Policy tools and FOMC decisions
• Bank of England: Interest rates and Bank Rate