What is the Overnight Rate?
The overnight rate is the interest rate at which a depository institution (such as a bank) lends or borrows funds from another depository institution in the overnight market. This interest rate is often set by the central bank of a country and plays a crucial role in monetary policy. Typically, the overnight rate is the lowest available interest rate and is provided to highly creditworthy institutions.
Key Takeaways
- Overnight rates are used for end-of-day lending between banks in the overnight market.
- These activities ensure banks meet federally mandated reserve requirements.
- Banks needing to meet reserve requirements borrow from surplus fund banks.
- Overnight rates are strong predictors of short-term interest rate movements and broader economic trends including employment and inflation.
- High overnight rates increase the cost for consumers to borrow money, as banks transfer these costs to their customers.
How the Overnight Rate Works
Banks’ liquidity fluctuates daily based on lending, withdrawals, and deposits. A bank may end a business day with an excess or shortage of funds.
Banks with surplus funds lend to those with shortages to meet reserve requirements, ensuring systemic stability and liquidity. The overnight rate offers banks a cost-effective way to secure short-term funding from central bank depositories. As this rate is influenced by a nation’s central bank, it serves as a reliable indicator of short-term interest rate trends affecting consumers and the broader economy. Higher overnight rates indicate increased borrowing costs.
In May 2022, the Federal Funds rate was 0.77%, up from April’s 0.33%. In the U.S., the overnight rate is termed the ‘federal funds rate,’ whereas in Canada, it is called the ‘policy interest rate.’ The rate rises and falls with liquidity levels, reflecting the health of the national economy and banking system.
Effects of the Overnight Rate
The overnight rate impacts long-term rates such as mortgage rates. As it rises, banks face higher settlement costs, compelling them to raise longer-term rates to balance the extra expense.
The Federal Reserve controls the overnight rate in the U.S. through open-market operations, indirectly influencing employment, growth, and inflation. Rates have ranged from a high of 20% in the early ’80s to 0% post-Great Recession (2007-08).
Bank Rate vs. Overnight Rate
Although often confused, the bank rate or discount rate differs from the overnight rate. The bank rate is the charge for banks borrowing directly from the central bank. The overnight rate (or federal funds rate) is the rate for inter-bank borrowing.
Why Do Banks Borrow Overnight?
Banks must maintain a minimum reserve set by the central bank to ensure liquidity. Daily fluctuations in deposits and withdrawals affect reserves. In need, banks borrow from surplus-holding banks to meet requirements.
Influence on the Prime Rate
When central banks hike the overnight rate, inter-bank borrowing costs rise. Consequently, banks increase their prime rates, heightening consumer borrowing costs. Essentially, banks transfer the higher borrowing costs to consumers.
Related Terms: Federal Funds Rate, policy interest rate, liquidity, reserve requirements.
References
- Federal Reserve Bank of St. Louis. “Federal Funds Effective Rate”.
