What is the Overnight Rate

The overnight rate is the interest rate at which a depository institution (generally banks) lends or borrows funds with another depository institution in the overnight market. In many countries, the overnight rate is the interest rate the central bank sets to target monetary policy. In most circumstances the overnight rate is the lowest available interest rate, and as such, it is only available to the most creditworthy institutions.

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Overnight Rate

Basics of Overnight Rate

The amount of money a bank has fluctuates daily based on its lending activities and its customers' withdrawal and deposit activity. It may experience a shortage or surplus of cash at the end of the business day. Those banks that experience a surplus often lend money overnight to banks that experience a shortage of funds to maintain their reserve requirements. The requirements ensures that the banking system remains stable and liquid.

The overnight rate provides an efficient method for banks to access short-term financing from central bank depositories. As the overnight rate is influenced by the central bank of a nation, it can be used as a good predictor for the movement of short-term interest rates for consumers in the broader economy. The higher the overnight rate, the more expensive it is to borrow money. In the United States, the overnight rate is referred to as the federal funds rate, while in Canada, it is known as the policy interest rate. The rate increases when liquidity decreases (when loans are more difficult to come by) and falls when liquidity increases (when loans are more readily available). As a result, the overnight rate is a good indicator of the health of a country's overall economy and banking system.

Effects of the Overnight Rate

The overnight rate indirectly affects mortgage rates in that as the overnight rate increases, it is more expensive for banks to settle their accounts, so to compensate they will increase longer-term rates. 

The Federal Reserve influences the overnight rate in the United States through its open-market operations. The overnight rate, in turn, affects employment, economic growth, and inflation. This rate has been as high as 20% in the early 1980s and as low as 0% after the Great Recession of 2007. 

Key Takeaways

  • Overnight rates are the rates at which banks lend funds to each other at the end of the day. The aim of these lending activities is to ensure maintenance of federally-mandated reserve requirements.
  • Overnight rates are predictors of short-term interest rate movement in the broader economy and they can have a domino effect on various economic indicators such as employment and inflation.