A benchmark rate is, as it sounds, an interest rate which serves as a benchmark by which other interest rates are assessed. The benchmark rate represents the lowest interest rate, and it fluctuates in response to a wide variety of pressures. Many people use the interest rate set by central banks as a benchmark rate, with all other interest rates being pegged to this benchmark.
In the case of the interest rate set by central banks, the rate is set by government officials who periodically meet to adjust the rate, if necessary. The government wants to keep the rate low enough to promote lending and financial growth, but not so low that there is no opportunity for profit. Central banks actually set several interest rates; the rate of most interest is the rate for overnight lending.
Government securities use the benchmark interest rate to determine their rate of return. The rate of return on such securities is low, but they are also low-risk, because they are backed by the government. Interest rates for other types of securities are higher, potentially generating more returns although they are also associated with more risks. When interest rates are set, people consider the benchmark interest rate, as potential purchasers of securities will not buy products yielding low interest.
Benchmark rates are also used by banks and other lenders to determine interest rates for their financial products, such as credit cards, home loans, and car loans. Historically, banks used the benchmark interest rate to determine the prime rate, the lowest interest they offered, and interest was offered in terms of the prime rate plus an additional percentage. For low-risk borrowers, a loan at prime rate might be obtainable, while high risk borrowers would have had to take a higher rate. Today, the prime rate and benchmark rate can differ.
Even for people who are not planning on investing or taking out a loan, it can be beneficial to pay attention to the benchmark rate and its fluctuations. Most newspapers announce changes in the rate, as do news broadcasts. Changes in the rate can be warning signs that the government is concerned about the flow of funds; if the rate is dramatically reduced, for example, it indicates that officials are worried about a credit freeze. If the rate is raised, it can indicate that an economy is in good condition, so the government has no worries about incentivizing lending.