Benchmark Interest Rate

Published on :

21 Aug, 2024

Blog Author :

Edited by :

Reviewed by :

A Benchmark Interest Rate is a standard interest rate used as a reference point for setting other interest rates. It is usually determined by central banks, financial institutions, or market participants and reflects the prevailing market conditions.

By using a common reference rate, participants can compare borrowing and lending costs across different financial markets and products. It can help standardize financial contracts and facilitate price discovery in financial markets. It is also known as the reference rate.

What Is Benchmark Interest Rate?

A benchmark interest rate is a standard rate that serves as a reference point for determining other interest rates. It is also termed as reference rates.
Central banks and financial institutions set reference rates considering market demand, economic conditions, and interest rates.
The federal funds rate is also used as a benchmark for other interest rates in the US financial system. The Federal Reserve can influence the cost of borrowing and lending throughout the economy by adjusting the federal funds rate, thereby affecting economic growth and inflation.
The primary difference between reference rates and prime rates is that the latter is a specific interest rate used by banks to price loans to the most creditworthy customers.

Benchmark Interest Rate Explained

A benchmark interest rate is used as a standard for pricing financial products and contracts. Typically, financial institutions use reference rates to determine the interest rates they charge for loans and other financial products. For example, if a bank offers a variable rate mortgage, it may be tied to a reference rate such as the London Interbank Offered Rate (LIBOR). Thus, the bank adds a percentage to the LIBOR rate, which determines the borrower's interest rate. As the LIBOR rate changes, so does the interest rate on the mortgage.

Similarly, a company may issue a bond that pays interest based on a reference rate plus a fixed spread. The reference rate sets the bond interest standard, while the spread indicates the issuer's credit risk.

Central banks and financial institutions set reference rates based on factors like market demand, economic conditions, and interest rates. They determine interest rates for various financial products like loans, bonds, and derivatives.

The Federal Reserve benchmark interest rate also serves as a benchmark for other interest rates in the US financial system. Credit card rates and adjustable-rate mortgages often link to short-term reference rates like the federal funds rate or the prime rate that banks set for their top clients.

The federal funds rate is a key tool of monetary policy in the United States. The Federal Reserve adjusts the federal funds rate to impact borrowing and lending costs in the economy, influencing economic growth and inflation. During economic weakness, the Fed lowers rates to spur borrowing and boost economic activity. When the economy grows rapidly, causing inflation, the Federal Reserve might raise rates to control inflation.

Examples

Let us look at some examples to understand the concept better:

Example #1

Let us say that a bank wants to offer a loan to a customer for a 5-year term. The bank may use the 5-year Treasury yield as a reference rate to price long-term loans in the United States.

Assuming that the 5-year Treasury yield is currently 2%, the bank might offer the loan at a fixed interest rate of 4%, which is 2% higher than the benchmark rate. The loan's fixed interest rate is 4% for the full 5-year term, unaffected by changes in the 5-year Treasury yield.

Alternatively, the bank might offer a variable rate loan, which could tie to a different reference rate, such as the prime rate, which banks charge to their best customers for loans. The bank might offer the loan at a variable interest rate of prime plus 2%, meaning that the interest rate on the loan would fluctuate as the prime rate changes over time.

Example #2

According to an article published on March 21, 2024, the US Federal Reserve has announced its second interest rate decision for 2024, keeping the reference rates unchanged at 5.25–5.50% for the fifth consecutive meeting. Despite persistent inflation, the central bank has kept its key overnight interest rate at a 23-year high since July and forecasts three rate cuts in 2024. Fed policymakers expect fewer rate cuts in 2025 and have slightly raised US core inflation and gross domestic product (GDP) growth forecasts for 2024. The Fed's long-term goal is to achieve maximum employment and inflation at 2%, but the economic outlook is uncertain.

The forecasting of interest rates at the end of 2024 is 4.50 to 4.75%, indicating that policymakers anticipate 0.75% point cuts before the end of the year, which will probably translate into three 0.25% point cuts. However, they now predict only three cuts in 2025.

Benchmark Interest Rate vs Prime Rate

The differences between the two concepts are as follows:

Benchmark Interest Rate	Prime Rate
A general term that refers to any interest rate that is widely used to price financial products. It is typically an average of interest rates that are determined in a particular market or region, such as LIBOR or the federal funds rate.	The prime rate is a specific interest rate that banks use to price loans to their most creditworthy customers.
It can be used to price financial products for a wider range of borrowers, from individuals to small businesses to large corporations.	It is typically only available to the most creditworthy borrowers, such as large corporations and high-net-worth individuals.
They are often more stable and less susceptible to short-term fluctuations.	It is more volatile as it can be affected by changes in the creditworthiness of individual borrowers and changes in the cost of funds for individual banks.

Frequently Asked Questions (FAQs)

Why is benchmark interest rate important?

Central banks often use reference rates to implement monetary policy. For example, when the economy is weak, a central bank may lower its reference rates to encourage borrowing and spending, which can stimulate economic growth. In an overheating economy, the central bank may raise rates to curb inflation and slow growth.

How is the benchmark interest rate calculated?

The calculation of reference rates depends on the specific rate in question. Different reference rates are calculated using different methods and based on different underlying factors. Reference rates are determined by market conditions and factors influencing credit supply and demand in a specific market. Rates rely on reliable data and are widely acknowledged as a pricing standard for financial products.

What is the benchmark interest rate index?

An index that calculates the interest rate of a specific financial instrument or bunch of financial instruments. A reference rate index benchmarks interest rates for services like mortgages, helping lenders set charges.