Understanding the Overnight Rate and Its Economic Impact

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The overnight rate is the interest rate banks charge one another for loans repaid the next business day. It is the shortest-term borrowing cost in the banking system and the main policy lever for many central banks. In the United States, it is the federal funds rate. In Canada, the central bank’s policy target is officially called “the overnight rate.” The target central banks set for it influences the cost of nearly every other loan in the economy.

What the Overnight Rate Is

A bank’s cash position changes all day as deposits, withdrawals, loan fundings and payments settle. By the close of business, some banks hold more reserves than they want and others hold less. Banks with a surplus lend it overnight to banks with a shortfall, and the loan is repaid the next morning with interest.

These loans are among the lowest-risk lending in the financial system. The term is one day, and the borrowers are regulated institutions with access to central bank facilities. As a result, the rate is typically among the lowest available, and only creditworthy banks can borrow at it.

Why Banks Borrow Overnight

The traditional reason was reserve requirements: a bank that fell short of its required reserves at day’s end borrowed overnight to close the gap. The Federal Reserve cut U.S. reserve requirements to zero in March 2020, but banks still borrow overnight for other reasons:

• To settle payments and keep enough cash in their reserve accounts
• To meet internal and regulatory liquidity targets
• Because borrowing for one night costs less than raising longer-term funding for a short-term gap

Calculating Interest on an Overnight Loan

U.S. money markets quote overnight rates as annual figures and usually calculate interest on an actual/360 day count.

Interest = Principal × Annual rate × (Days ÷ 360)

Hypothetical example: Bank A lends Bank B $50 million overnight at an annualized rate of 4.00%.

$50,000,000 × 0.04 × (1 ÷ 360) = $5,555.56

If the same loan is made on a Friday and repaid on Monday, it runs three calendar days, and the interest is $16,666.67.

How Central Banks Steer the Rate

The Federal Reserve’s Federal Open Market Committee (FOMC) sets a target range for the federal funds rate, such as a quarter-point band, rather than the price of each loan. Its tools keep actual trading within the band:

• Interest on reserve balances (IORB): Banks earn this rate on reserves held at the Fed, so they have little reason to lend overnight for less.
• Overnight reverse repurchase facility: Money market funds and other non-bank lenders can place cash with the Fed at a set rate, which supports the bottom of the range.
• Open market operations: Buying or selling securities adds reserves to the banking system or drains them.
• Discount window: Banks can borrow directly from the Fed at a rate above the range, which limits how high market rates can rise.

Liquidity also matters. Scarce reserves push the rate up, and plentiful reserves push it down. Where the market rate trades relative to the target is one gauge of stress in the banking system.

Why Controlling the Overnight Rate Matters

When the target rises, banks pay more for short-term funds and charge more on loans. The clearest link is the U.S. prime rate, which by convention is the upper end of the fed funds target range plus 3 percentage points. Credit card APRs, home equity lines and many small business loans are priced off prime, so they reprice soon after a policy change.

Higher borrowing costs slow spending and investment, easing demand-driven pressure on prices measured by the Consumer Price Index. Lower rates are meant to support employment and growth, in line with the Fed’s mandate of maximum employment and stable prices. The Fed pushed rates to about 20% in the early 1980s to fight double-digit inflation (see U.S. inflation by year). It held the target at 0% to 0.25% after the 2008 crisis and again in 2020.

Overnight Rate vs. Related Rates

Overnight rate vs. federal funds rate. “Overnight rate” is the general term for interbank overnight lending. The federal funds rate is the U.S. version, and references to it usually mean the FOMC’s target range.

EFFR vs. OBFR. The New York Fed publishes the effective federal funds rate (EFFR), which is the volume-weighted median of overnight fed funds trades. It also publishes the Overnight Bank Funding Rate (OBFR), which adds Eurodollar transactions, meaning dollar deposits held at banks outside the U.S. Both are calculated from actual trades. Neither one is the target range.

Bank rate (discount rate) vs. overnight rate. The discount rate is what the central bank charges banks that borrow directly from it, and it sits above the overnight rate banks charge each other.

SOFR. The Secured Overnight Financing Rate measures overnight borrowing backed by Treasury securities in the repo market. It is secured, while fed funds loans are unsecured.

Overnight bank deposit rates. Some brokerages and banks pay rates on cash swept overnight. These are rates set for customers, and they are generally below the interbank rate.

Limitations

• A target is not a fill price. The market rate can drift within the target range and, under stress, briefly trade outside it.
• Pass-through is uneven. Prime-linked loans adjust quickly. Fixed mortgage rates follow longer-term Treasury yields, which depend on inflation and growth expectations as well as the current overnight rate, and sometimes move in a different direction.
• Effects take time. Policy changes affect inflation and employment with long and variable lags.
• The zero lower bound. When the rate is already near zero, further cuts are limited, and central banks turn to tools such as asset purchases.

The Bottom Line

The overnight rate matters to anyone with a credit card, home equity line or small business loan priced off prime, since those reprice soon after a policy change. Fixed mortgage rates follow longer-term Treasury yields and can move differently. Watching the Fed's target range gives borrowers an early signal of where variable loan costs are heading, though effects on inflation and jobs arrive with long lags.