The overnight rate plays a crucial role in macroeconomics by impacting unemployment, inflation, and economic growth.
What is the Overnight Rate?
The overnight rate refers to the interest rate that depository institutions (e.g., banks or credit unions)charge each other for overnight lending. Note that the overnight rate is called something different in different countries. For example, in the United States, it is known as the Federal Funds rate, while in Canada it is called the policy interest rate. Overnight rates are good 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.
Breaking Down Overnight Rate
The overnight rate is tied to banking operations and liquidity, with banks experiencing fluctuations in their liquidity due to various factors such as cash withdrawals, lending activities, and liabilities. Banks are required to maintain reserve requirements set by the central bank, which are a percentage of their deposits that cannot be used for lending. Overnight lending was introduced to help banks access short-term financing and address liquidity shortages. Central banks, like the Federal Reserve in the United States or the Bank of Canada, oversee lending rates and set target rates or ranges. While they can't enforce the target rate, they may use open market operations to influence rates. This can involve purchasing government bonds to inject cash and lower the rate or selling government securities to create a liquidity shortage and raise the rate.
How the Overnight rate impacts the Monetary policy?
The overnight rate plays a crucial role in macroeconomics by impacting unemployment, inflation, and economic growth. It indirectly influences mortgage rates, as higher overnight rates make it costlier for banks to settle their accounts, leading them to raise longer-term rates, including mortgage rates.
In the United States, the Federal Reserve influences the overnight rate through its open-market operations. This rate, in turn, has implications for employment, economic growth, and inflation. Throughout history, the overnight rate has reached highs of 20% in the early 1980s and lows of 0%following the Great Recession of 2007-08.
Central banks utilize the overnight lending rate as a tool for implementing monetary policies. When the economy shows signs of sluggish growth, the central bank may lower the overnight rate to stimulate economic expansion. This enables banks to borrow funds at a reduced rate, leading to lower interest rates for businesses and individuals. Consequently, this encourages investment, expansion, and enhances consumer purchasing power.
Conversely, in the case of an overheating economy and rising inflation,the central bank may raise the overnight rate as part of a contractionarymonetary policy. This increase serves to discourage excessive overnight lendingby banks, compelling them to raise interest rates for their customers. As aresult, the circulation of money in the economy decreases, curbing inflation,but it may also discourage business activities.
Recent trends ofFederal funds rate and policy interest rate
Effective Federal Funds Rate is at 5.07%, compared to 5.07% the previous market day and 1.58% last year. This is higher than the long term average of 4.60%.
Canada Target Overnight Rate is at 4.75%, compared to 4.75% the previous market day and 1.50% last year. This is higher than the long term average of 2.63%.
Toronto Dominian (TD) Bank has recently forecasted the Economic and Interest Outlook for U.S. and Canada which as follows:
Interest Rate Outlook
Canadian Economic Outlook[Period-Over-Period Annualized Per Cent Change Unless Otherwise Indicated]
United States Economic Outlook[Period-Over-Period Annualized Per Cent Change Unless Otherwise Indicated]
The increase in the overnight rate in both the United States and Canada has implications for the monetary policy of both economies, playing a vital role in macroeconomics by influencing unemployment, inflation, higher longer-term rates including mortgage rates, and economic growth. This has resulted in lower GDP growth, increased unemployment, and inflation, according to estimations.