What is an interest rate, and what is a central bank policy rate?
Short answer
An interest rate is the price of borrowing money, stated as a percentage of the amount borrowed per period. A central bank policy rate is the benchmark rate it sets to steer short-term borrowing costs across the economy.
Interest as the price of money
When you borrow, you pay interest to the lender for using their money. When you deposit, the bank pays you interest. The rate is quoted per period, usually per year, and applies to the principal, the amount borrowed or deposited.
Rates differ by borrower, loan length and risk. A lender usually charges more when it is less certain of being repaid or when the loan runs for longer.
What a policy rate is
Each central bank sets at least one benchmark rate for lending to, or borrowing from, commercial banks, usually overnight or very short term. This policy rate influences what banks charge each other and, in turn, rates on loans, mortgages and deposits.
The name and mechanics differ by country: the United States targets a range for the federal funds rate, India sets the repo rate, the United Kingdom sets Bank Rate, and the European Central Bank sets three key rates, including a deposit facility rate. Japan targets a short-term interbank rate.
Why central banks move it
Raising the policy rate generally makes borrowing more expensive and saving more rewarding, which tends to cool spending and inflation. Lowering it generally does the opposite. Central banks weigh price stability against employment and growth, and each states its mandate publicly.
The effect on any household or business depends on whether its loans carry fixed or floating rates, on lenders’ own funding costs, and on the wider economy. Changes in the policy rate also affect bond yields and exchange rates.
Nominal and real rates
The rate quoted on a loan or deposit is the nominal rate. Subtracting inflation gives an approximate real rate, which shows the change in purchasing power.
Simple interest = principal x annual rate x years