Base Rate

Trading Basics

What is a Base Rate?

Brief Overview: The base rate is the interest rate that the central bank of a country sets for retail banks. This trickles down and affects the prices of bonds, shares and exchange rates. In the UK, the Monetary Policy Committee decide the level of interest rate set.

Full Overview: Since the base rate impacts all other interest rates in an economy, understanding the base rate is crucially important to traders and investors. Here, we’ll shed light on a country’s base rate, the difference between the base rate and overnight rate, and how it affects the general state of an economy.

Base Rate Explained

The base rate is the interest rate at which a country’s central bank lends money to commercial banks. It’s the rate that a central bank will charge domestic banks for loans. The base rate is very important for the health of the economy, and a country’s central bank uses the base rate to impact economic activity in a country.

Conversely, a higher base rate is often passed on to the end consumer in the form of higher interest rates on consumer loans and mortgages. The base rate is also known as the base interest rate or bank rate.

Although banks in most countries are free to determine the interest rates at which they’ll borrow funds, those rates are typically based on the central bank’s base rate. Depending on the current economic conditions of a country, a central bank can impact the amount of consumer loans and encourage or discourage spending simply by adjusting the country’s base rate.

However, lower interest rates don’t only encourage spending and help support an economy that is slowing down but also reduce returns on savings.

Read: How Does the Bank of England Decide its Bank Rate?

Base Rate vs Overnight Rate

Don’t confuse the base rate with the overnight rate. The overnight rate refers to the rate at which domestic banks lend money to each other to cover deficiencies in their reserves. The reserve requirement is the percentage of a bank’s deposits that must be held in cash, which means that the higher the reserve requirement, the fewer room commercial banks have to lend to end consumers.

Banks are required to meet the minimum reserve requirements by keeping a certain percentage of their deposits on hand. In case those reserves fall below a certain threshold by the end of the day, banks will borrow funds from other banks at the overnight rate to meet the minimum reserve requirements.

Sometimes, when the base rate is lower than the overnight rate, commercial banks will turn to the central bank to borrow funds instead to other commercial banks. This means that the overnight rate is often impacted by the base rate.

How Base Rates Affect the Economy

The base rate has an important effect on the general state of the economy. As mentioned earlier, a lower base rate typically encourages banks to reduce their lending rates to the end consumer. This makes borrowing more attractive and encourages consumer spending as returns on savings are reduced. It also helps companies to borrow at lower costs and fund expensive capital projects, having a positive impact on economic growth.

Central banks usually lower the base rate when the economy shows signs of weakness and inflation rates creep below the central bank’s target. In the financial crisis of 2007 and 2008, major central banks around the world kept base rates at a very low level to encourage spending and to support economic activity.

When a central bank increases the base rate, this cost is typically passed on to the consumer by making borrowing more expensive. As a result, higher base rates discourage spending and encourage saving as returns on saving accounts increase.

Did you know?

Central banks usually hike the base rate to prevent an economy from overheating and to keep inflation rates under control.

Besides the base rate, central banks can also control the current money supply in the economy through open market operations and the reserve requirement. Open market operations (OMO) refer to the purchasing and selling of US Treasuries on the open market in order to affect the current money supply, while reserve requirements are the minimum amount of cash that banks must have on hand. Central banks usually increase reserve requirements during economic recessions in order to stabilise the financial sector.

The Federal Reserve and the Base Rate

In the United States, the base rate is set by the country’s central bank, the Fed. The Federal Reserve charges the base rate on loans extended to commercial banks in order to control liquidity in the system and reduce pressures on the reserve requirements.

Unlike the overnight rate (federal funds rate) which is set by the FOMC, the base rate is set by the Fed’s board of governors. Since the Fed is considered a lender of last resort, the base rate is usually higher than the overnight rate.

At the end of each day, commercial banks can have cash on hand that exceeds the minimum reserve requirements. In that case, those banks will usually lend the excess funds to other banks at the current overnight rate.

However, sometimes when the overnight lending system is maxed out, banks that need to borrow money to meet their reserve requirements have to turn to the Fed as the lender of last resort. That’s why the Fed base rate is usually set one percentage point above the overnight (funds) rate and why banks prefer to borrow from other commercial banks at the overnight rate rather than the Fed.

Final Words

The base rate is the rate at which a country’s central bank, such as the Federal Reserve or Bank of England, lends money to commercial banks and depository institutions. The base rate is closely followed by traders and investors as it sets the path for other interest rates in an economy.

When the base rate increases, banks have to pay more on funds borrowed from the central bank, with the cost usually passed on to the bank’s customers. As a result, companies and other borrowers will have to pay higher rates on their loans and mortgages, which in turn reduces overall economic activity.

Similarly, when the base rate decreases, commercial banks have to pay less to borrow from the central bank and interest rates on loans and mortgages get lower, stimulating economic activity and spending. That’s why central banks use the base rate to support the economy in times of recessions or to cool down an overheating economy from forming a bubble.

Banks use loans from the central bank to meet their daily reserve requirements. Since the base rate is usually set at a higher rate than the overnight rate, banks prefer to borrow funds among each other and only use the central bank as a lender of last resort.

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