Overnight Rate

Overnight Rate: Definition and Economic Impact

Key takeaways
* The overnight rate is the interest rate at which banks lend reserve balances to one another for one business day.
* It is typically the lowest short-term rate and is available only to highly creditworthy institutions.
* Central banks target or influence the overnight rate to conduct monetary policy; changes eventually affect consumer borrowing costs and macroeconomic conditions.

What the overnight rate is
The overnight rate (often called the federal funds rate in the U.S.) is the interest rate banks charge each other for unsecured, very short-term loans to meet reserve requirements. Because these loans are extremely short-term and between regulated institutions, the overnight rate sits at the short end of the yield curve and serves as a benchmark for other interest rates in the economy.

How it works
* Daily liquidity needs: Banks’ deposit and lending flows change day to day. Some institutions end a business day with a surplus of reserves; others have a shortfall.
* Interbank lending: Banks with excess reserves lend overnight to those with deficits so all institutions meet reserve requirements.
* Central bank influence: Central banks influence the overnight rate through tools such as open-market operations, standing lending/borrowing facilities, and reserve policy. By tightening or easing these tools, central banks raise or lower the overnight rate.

Why it matters for the economy
* Transmission to consumer rates: When the overnight rate rises, banks’ funding costs increase. Banks commonly pass these higher costs on by raising prime rates, mortgage rates, and other consumer and business lending rates. The reverse happens when the overnight rate falls.
* Indicator of monetary stance: Movements in the overnight rate signal the central bank’s stance—restrictive, neutral, or accommodative—which affects spending, investment, employment, and inflation.
* Liquidity and financial stability: A stable overnight market ensures banks can meet short-term needs without sudden funding stress. Sharp spikes in the overnight rate can indicate liquidity strains.

Common questions

Is the bank rate the same as the overnight rate?
No. The bank rate (sometimes called the discount rate) is the rate at which commercial banks borrow directly from the central bank. The overnight rate is the interbank lending rate between commercial banks.

Why do banks borrow overnight?
Banks borrow overnight to meet reserve requirements and smooth daily liquidity fluctuations caused by withdrawals, deposits, and loan settlements. Borrowing overnight is typically cheaper than other short-term funding options.

How does the overnight rate affect the prime rate?
Banks set prime rates and other retail lending rates based partly on wholesale funding costs. When the overnight rate rises, those costs increase, and banks often raise prime rates to maintain margins, making loans more expensive for consumers and businesses.

Historical context
The overnight rate has varied widely over time depending on monetary policy and economic conditions—from very low levels near zero during periods of extreme easing to double-digit rates in eras of high inflation and tight policy. Its level and direction are central to macroeconomic management.

Bottom line
The overnight rate is a foundational short-term benchmark that reflects banking system liquidity and the central bank’s monetary stance. Though many consumers do not follow it directly, shifts in the overnight rate ripple through financial markets and lending rates, influencing inflation, growth, employment, and everyday borrowing costs.