The Target Overnight Rate
What is the target overnight rate?
The target overnight rate is a key Bank of Canada-controlled interest rate used as a basis for one-day (or “overnight”) borrowing between the major lenders and financial institutions. This rate plays a pivotal role in influencing the economy.
The pivotal role played by the Bank of Canada’s target overnight rate
The target overnight rate is the primary monetary policy instrument available to the Bank of Canada. By changing the overnight rate, the Bank of Canada can assert short-term control on the demand. They can also control the availability of credit products across the board. This control causes a delayed, but direct, effect on the level of inflation of the Canadian dollar.
When the overnight rate is decreased, the cost of credit decreases, mortgage rates fall, and consumer demand for credit products rises. In situations where the overnight rate has fallen, it also becomes easier for banks and lending institutions to provide credit for consumers. This is because it’s less expensive for them to lend among themselves.
The opposite is also true, that in increasing the overnight rate, the cost of credit increases, and, temporarily, demand sinks.
The Bank of Canada’s monetary policy and focus on inflation
The primary role of the Bank of Canada is to contribute to a healthy Canadian economy. It has been well established since the 1970’s, the high rates of inflation cause uncertainty in the market. In the long run, this causes damage as well. As a result, one of the primary goals of the Bank of Canada is to keep inflation at a minimum level.
The short- and long-term effects of target overnight rate changes
In the short-term, decreasing the overnight rate can be done to influence important economic elements. Those economic elements are the unemployment rate, income levels, and the rate of market growth.
In the long-term, effects from changing the overnight rate are overcome by market adjustments in wages. These are due to excess demand or supply. Keeping the overnight rate low increases the rate of inflation.
Increasing the overnight rate makes Canadian investment products more attractive to foreign investment firms. This increases demand for the Canadian dollar which increases its relative value.
A higher Canadian dollar makes foreign goods less expensive, quelling domestic inflationary pressures. In the long-term, this has an overall positive effect on the economy.
The Bank of Canada’s policy on the value of the target overnight rate
In December of 2000, the Bank of Canada started a system of changing the target for the overnight rate on only eight pre-announced days per year. As a matter of policy, the Bank of Canada attempts to keep the overnight rate within a target range of 1% to 3%.
Since the beginning of 2009, the overnight rate in Canada has been relatively low. January of 2009 saw the overnight rate at 1.00%. In a matter of 3-5 months, this rate quickly dropped in response to the worldwide credit crisis. This led to the lowest overnight rate in recent history.
By the last quarter of 2009, the overnight rate dropped to an unprecedented 0.25%. The overnight has since returned to 1.00% and stayed steady since then.