Overnight Rate (Federal Funds Rate): Definition and How It Works

By
James Chen
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James Chen, CMT is an expert trader, investment adviser, and global market strategist.

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Updated June 10, 2022
Reviewed by Eric Estevez
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Pete Rathburn
Pete Rathburn
Fact checked by Pete Rathburn
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Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom.

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What Is the Overnight Rate?

The overnight rate is the interest rate at which a depository institution (generally banks) lends or borrows funds from 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.

Key Takeaways

  • Overnight rates are the rates at which banks lend funds to each other at the end of the day in the overnight market.
  • The goal of these lending activities is to ensure the maintenance of federally-mandated reserve requirements.
  • When a bank cannot meet its reserve requirement, it will borrow from a bank that has a surplus reserve.
  • Overnight rates are predictors of short-term interest rate movement in the broader economy and can have a domino effect on various economic indicators such as employment and inflation.
  • The higher the overnight rate is, the more expensive it is for consumers to borrow money, as the increased cost to banks is passed onto consumers.
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Overnight Rate

How the Overnight Rate Works

The amount of money a bank has fluctuates daily based on its lending activities and its customers' withdrawal and deposit activity. A bank 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 so as to maintain their reserve requirements. The requirements ensure 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.

As of May 2022, the Federal Funds rate sits at a rate of 0.77%; an increase from the previous month's rate of 0.33%.

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 raise 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 2007-08.

Is the Bank Rate the Same as the Overnight Rate?

No, the bank rate and the overnight rate are not the same. The bank rate is also known as the discount rate, which is the rate that banks can borrow from the central bank. The overnight rate, also known as the federal funds rate, is the rate at which banks can borrow from one another.

Why Do Banks Borrow Overnight?

Banks are required by the central bank to keep a minimum amount of reserves to ensure liquidity in the banking sector. The reserves of banks fluctuate depending on customer withdrawals and deposits. When banks have a shortfall and cannot meet their reserve requirement, they will borrow from banks with a surplus to do so.

How Does the Overnight Rate Affect the Prime Rate?

When the overnight rate is increased by the central bank, it becomes more expensive for banks to borrow money from one another, increasing their total cost. To make up for this increase in costs, banks increase their prime rates, which makes borrowing money for customers more expensive. In essence, banks pass the increased cost onto the consumer.

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  1. Federal Reserve Bank of St. Louis. "Federal Funds Effective Rate."