Definitions of the various types of interest rate
- Central bank rate - is the one most generally referred to in the financial press when they talk about the ‘bank rate’ or ‘interest rate’ without further specification (except for the USA, see below). Set by policymakers and usually the key rate upon which others are based. Also called the ‘base rate’ in the UK, ‘cash rate’ in Australia and New Zealand, and ‘discount rate’ in the USA. It’s the rate at which the central bank lends money overnight to commercial banks.
- Federal funds rate - specifically in the USA, policymakers at the Federal Reserve use a slightly different mechanism for influencing the nation’s interest rates. The federal funds rate is the overnight rate at which banks lend reserve balances to each other. The Federal Reserve Open Market Committee (FOMC) sets a target for this rate and implements monetary policy through ‘open market operations’ - buying or selling government securities (Treasury bills and bonds) in the open market. Buying securities will increase the money supply, lowering rates. Selling securities will decrease the money supply, increasing rates.
- Lending rate - also called ‘Prime interest rate’ or just ‘Prime rate’ is the rate at which banks lend to prime creditworthy customers - usually a fraction of a percent above the central bank rate.
- Deposit rate - the interest rate offered by banks to customers saving for an agreed period time at a fixed interest rate. Deposit rates directly influence investor decisions to save or invest in other asset classes.
- Interbank rate - usually refers to LIBOR (London Inter-Bank Offer Rate) which is the average interbank interest rate at which a selection of banks on the London money market are prepared to lend to one another. LIBOR is published daily in 5 currencies USD, EUR, JPY, GBP and CHF.
- Real interest rate - an interest rate adjusted for inflation, for example if you deposit money at the bank at a rate of 0.5% per annum, but inflation is currently 1%, then in real terms you are losing 0.5% annualised (i.e. a real interest rate of -0.5%). Government statistics for various countries typically define the nations real interest rate as the lending rate adjusted by inflation using the GDP deflator (a measure of GDP price inflation/deflation with respect to a specific year, unlike the consumer price index (CPI) which is measured using a fixed basket of goods and services).
- Neutral interest rate - also called the natural interest rate, is the theoretical central bank rate at which the economy is growing at it’s natural trend rate and inflation is stable. The long term view on the natural interest rate is an important benchmark for policymakers.
- Nominal interest rate (1) - refers to an interest rate before adjustment for inflation.
- Nominal interest rate (2) and effective interest rate - nominal rate can also refer to the annualised rate where the payment period is different to the base period; also called the APR (annualised percentage rate). The effective rate takes account of the compounding effect in the calculation. For example, interest paid monthly at 0.6434% is a nominal 12 x 0.6434 = 7.72% APR, but when compounded is an effective rate of 8.0% p.a.*
*To compound up from nominal rate i, to effective rate r, where n is the number of periods in a year, the formula is:
This is easy enough to drop into a spreadsheet. If you want to go the reverse direction, then juggle to solve for i. Drop this into an Excel cell, “=EXP(LN(1+$A$1)/12)-1”. For example, put 8% into cell $A$1 and the formula will show the result 0.6434%.