The target for the Overnight Rate: At the Bank of Canada(BoC), the primary tool they use to control inflation is their target for the overnight rate – also called the policy interest rate. This is the starting point for setting many of the interest rates in the economy that matter for Canadians.
The Overnight Market: Every business day, Canada’s financial institutions move money back and forth among themselves for their customers. Whenever you use your debit card or send an e-transfer, money flows between financial institutions. At the end of each day, they need to settle all these payments. Some institutions may have sent out more in payments than they received, while others may have received more than they sent. To get back to balance, financial institutions can borrow money from each other for one day in the overnight market. The Bank sets a target for the interest rate they want financial institutions to charge each other when they make these overnight loans.
Deposit rate and bank rate: Financial institutions don’t have to borrow from each other to get back to daily balance – they can also use BoC. They can deposit money with BoC at the deposit rate for one night, or borrow money from them at the bank rate for one night.
The range between the deposit rate and the bank rate-called their operating band – is usually one-half of a percentage point wide, with their policy interest rate sitting in the centre. For example, if the Bank sets the policy interest rate at 2.25%
- the lower end of the range is 2% – the deposit rate
- The higher end of the range is 2.5% – the bank rate
The difference between the deposit rate and the bank rate, encourages financial institutions to do this borrowing and lending with each other instead of coming to the BoC.
- Bank A has extra money. It can earn more interest by lending that money to Bank B than by leaving it with BoC and earning the deposit rate
- At the same time, Bank B needs money. It would rather borrow at a lower rate than at BoC Bank rate. So, it’s better for Bank B to borrow from Bank A.
This give a powerful incentive for banks to borrow and lend within this band. When BoC adjust their policy interest rate, they also adjust the deposit rate and the bank rate by the same amount to maintain the operating band.
What it all means for you
The public doesn’t access this overnight market to borrow or lend money. Still the BoC policy rate and this market are important to you. By encouraging financial institutions to borrow and lend among themselves at close to the policy rate, the Bank affects interest rates on all kinds of other borrowing in the economy, including:
- the prime rate of commercial banks (used for loans such as Lines of Credit)
- Mortgage Rates
- Interest rates paid on deposits, guaranteed investments certificates and other savings.
Why change the target
If the economy is struggling to grow, it could pull inflation significantly below 2%. In response, BoC might lower the policy rate so that other interest rates across the economy go down. This means:
- People and businesses pay lower interest on loans and mortgages and earn less interest on savings.
- With lower rates, people tend to spend more, boosting the economy.
But if the economy is growing too fast, it could lead to rising inflation. So BoC might raise the policy rate, which means:
- People and businesses pay higher interest on loans and mortgages. this discourages them from borrowing, reduces their spending and puts the brakes on inflation.
- With higher rates, people tend to save more and spend less, slowing down the economy
Original article: www.bankofcanada.ca