Overnight Rate, Base Lending Rate & Inflation – The Correlation

Refers to the interest rate at which a financial institution lend liquid funds (immediately available money) to another financial institution overnight. This overnight rate is determined by central bank, as in Malaysia, Bank Negara Malaysia during its Monetary Policy Meeting and it is a standardized rate for which banks can access short-term financing from central bank depositories.

Quoted in percentage, it is the cost of borrowing money from financial institutions.

For house owners and buyers, this all seem familiar – you want the lowest interest rate for your mortgage loan. However, at any given time, base lending rate is fixed, so the only variable in this equation is the percentage discount (BLR minus) or premium (BLR plus) from the Base Lending Rate.

 The Base Lending Rate is adjusted in correlation to Overnight Rate. The cause and effect of Overnight Rate adjustment is vast in terms of micro and macro economics, but suffice for this post here to illustrate the direct factors and effects.

 

 Hike in the cost of borrowing has the intention of slowing down consumer demand & spending in a overheated economy, usually characterized by a steadily increasing inflation rate, uptrending share market and business activity. Example, the recent 25 bps in Overnight Rate translates into 35 bps in Base Lending Rate at 6.60%.

 

Think of it this way in layman terms – when it cost more to borrow money, consumer spending power will reduce. Demand-pull inflation is partly driven up by up-spiralling consumer demand, so when money supply drops, price will remain steady (or drops) in theory. Bear in mind that increase in money supply is usually the primary factor for demand-pull inflation, so hiking the Overnight Rate is probably the most effective way.

Raising the Overnight Policy Rate, therefore, must be timely else the economic growth will also be stunned. It is a double-edge sword.

The reverse is true during recession. In order to spur consumer spending in a lethargic economic condition, central bank will cut OPR to increase money supply.

The other thing observed from this is the almost equivalent increase in bps for risk-free asset rate of return, reflected in banks’ short term Fixed Deposit Rate. This is good news for  ultra conservative investors.

Read this illustration on the Cause & Effect of Business Cycle to understand more on how all these are correlated.

**OPR or Overnight Policy Rate is also known as interbank offered rate at other countries