Overnight Rate - Explained
What is the Overnight Rate?
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Table of ContentsWhat is the Overnight Rate?How Does the Overnight Rate Work?Basics of the Overnight RateEffects of the Overnight Rate
What is the Overnight Rate?
The overnight rate is the interest rate that credit institutions charge each other when lending and borrowing funds in the overnight market. In the United States, the overnight rate is referred to as the federal funds rate, while the Canadian government calls it the policy interest rate. Central banks, in most countries, sets the overnight rates to influence monetary policy. In some countries, the central bank also participates in the overnight trade and will borrow or lend funds to other banks.
How Does the Overnight Rate Work?
Although there exists an average overnight rate in which central banks set, the rate may vary between different countries. Banking institutions participating in the overnight lending set their rates. There are certain qualifications that banks need to meet to be able to participate in various overnight operations. Only the creditworthy banks and institutions can trade, as the interest rates are very low in the overnight market.
Basics of the Overnight Rate
The overnight rate concept relates to the bank's daily operations and liquidity of assets. The amount of liquid cash in the bank fluctuates due to its daily business operations. Lending money to customers, cash withdrawals, cash deposits, and other liabilities of the bank can cause liquidity shortages in the bank. Banks that have a shortage at the end of a business day can borrow overnight from the banks with a surplus to maintain their money reserves. Overnight lending helps the credit institutions to overcome their shortfalls in liquid cash. Centrals banks require banks to maintain their reserves to ensure the banking system is liquid and stable. Bank reserves are a percentage of the total deposits, and the money has to be set aside as cash. A bank cannot use the money in its lending operations, as this may deplete the money in the reserve. Overnight rate gives central banks an efficient way to lend funds to banks for a short period. Since central banks determine the overnight rate of a country, the rates can predict the short-term interest rates of the general economy. If the overnight rate is high, then it will be more expensive to borrow funds. If the overnight rates are low, then it means liquid cash is readily available for lending activities. In the end, an overnight rate helps to gauge the well-being of the banking system and the country's economy.
Effects of the Overnight Rate
An increase in the overnight rate may impact mortgage rates indirectly. It becomes costly for banks to settle their debts when the overnight rate is high. So they increase the rates on long-term loans to compensate for the high overnight rates. Overnight rates directly affect the country's inflation, employment, and economic growth. If there is proof that the economy is growing, the central bank may lower the overnight rate for monetary expansion. A lower rate means the credit institutions and banks can lend and borrow from each other more often and stimulate economic growth. Lower overnight rates also imply that loans will be more available to customers and businesses. The commercial sector gets to grow, as the additional funds expand businesses and attract investors. Expansion of commercial activities also increases the consumers purchasing power.