Target For The Overnight Rate

THE TARGET FOR THE OVERNIGHT RATE is the main tool used by the Bank of Canada to conduct monetary policy. It tells major financial institutions the average interest rate the Bank of Canada wants to see in the marketplace where they lend each other money for one day, or "overnight." When the Bank changes the Target for the Overnight Rate, this change usually affects other interest rates, including mortgage rates and prime rates charged by commercial banks.

 

Canada's major financial institutions routinely borrow and lend money among themselves overnight, in order to cover their transactions during the day. Through the Large Value Transfer System (LVTS), these institutions conduct large transactions with each other electronically. At the end of the day, the financial institutions need to settle with each other. One bank may have funds left over at the end of this process, while another bank may need money.

 

The trading in funds that allows all the institutions to cover their transactions is called the overnight market. The interest rate charged on those loans is called the overnight rate.

The Bank of Canada operates a system to make sure trading in the overnight market stays within its "operating band." This band, which is one-half of a percentage point wide, always has the Target for the Overnight Rate at its centre. For example, if the operating band is 4.25 to 4.75 per cent, the Target for the Overnight Rate would be 4.50 per cent.

Since the institutions know that the Bank of Canada will always lend them money at the rate at the top of the band, and pay interest on deposits at the bottom, there is no reason for them to trade funds at rates outside the band. The Bank can also intervene in the overnight market at the Target rate, if the market rate is moving away from the Target.

The Target sets the trend.

When the Bank changes the Target for the Overnight Rate, this sends a clear signal about the direction in which it wants short-term interest rates to go. These changes usually lead to moves in the prime rate at commercial banks, which serves as a benchmark for many of their loans. These changes can also indirectly affect mortgage rates, and the interest paid to consumers on bank accounts, GICs, and other savings.

When interest rates go down, people and businesses are encouraged to borrow and spend more, boosting the economy. But if the economy grows too fast, it can lead to inflation. The Bank may then raise interest rates to slow down borrowing and spending, putting a brake on inflation.

In choosing a Target for the Overnight Rate, the Bank of Canada picks a level that it feels will keep future inflation low, stable and predictable. Keeping inflation low and stable helps provide a good climate for sustainable economic growth, investment and job creation.

When comparing Canada's official interest rates with those of other countries, the Target for the Overnight Rate is the best rate to use. It is directly comparable with the U.S. Federal Reserve's target for the federal funds rate, the Bank of England's two-week "repo rate," and the minimum bid rate for refinancing operations (the repo rate) at the European Central Bank.

July 2001