The overnight rate refers to the interest rate that depository institutions (e.g., banks or credit unions) charge each other for overnight lending. Note that the overnight rate is called something different in different countries. For example, in the United States, it is known as the Federal Funds rate, while in Canada it is called the policy interest rate.
Breaking Down Overnight Rate
The concept of the overnight rate is closely related to banking operations and liquidity issues. The liquidity of a bank tends to significantly fluctuate due to its business operations. For example, cash withdrawals, lending activities, and other liabilities can lead to a liquidity shortage by a bank. In addition, each bank must maintain the reserve requirements set by the central bank.
Essentially, the reserve requirement is a specified percentage of the bank’s deposits that cannot be used in its lending activities. The funds must be set aside and kept in cash or on the account within the central bank. The concept of overnight lending was introduced to help depository institutions access short-term financing to meet unexpected obligations and overcome their liquidity shortfalls.
In most countries, lending rates are overseen by the central bank (e.g., the Federal Reserve in the United States or Bank of Canada in Canada). Commonly, the central bank sets a target rate or a target range for the rate. Note that central banks cannot force depository institutions operating under their jurisdiction to charge exactly the target rate in their overnight lending activities. The rates are set by the banks participating in the overnight market.
However, the central bank may encourage depository institutions to follow the interest rates within the target range through open market operations. For example, the central bank may start purchasing government bonds from the banks to inject more cash into the economy and lower the rate. Alternatively, if the central bank aims to increase the target rate, it may initiate a sale of government-issued securities to artificially create a liquidity shortage.
Overnight Rate and Monetary Policy
The overnight rate is one of the most important macroeconomic variables. Changes in the overnight lending rate may also influence other macroeconomic factors, including the unemployment rate, inflation, and economic growth rate.
Central banks manipulate the overnight lending rate to implement their monetary policies. For example, if evidence of slow economic growth emerges, the central bank can implement an expansionary monetary policy by bringing the overnight rate down to stimulate growth. A lower rate implies that the banks can borrow the funds from each other at a lower rate.
Subsequently, the banks can charge lower interest rates to their customers, making loans more affordable to businesses and individuals. Therefore, businesses are able to obtain additional funds for various investment and expansion activities while the purchasing power of consumers also increases.
Conversely, if a country’s economy is overheated and there are signs of rising inflation, the central bank may enforce a contractionary monetary policy by increasing the rate. The rate hike discourages banks from excessive overnight lending activities.
Thus, the banks will raise interest rates charged to their customers to compensate for the higher overnight rates. This leads to a decrease in money circulation in the economy, which prevents inflation. However, it also discourages business activities.