How does the policy rate influence other interest rates?
Once the Monetary Policy and Financial Stability Committee determines the policy rate, the Committee sets the banks' deposit and lending rates in Norges Bank. This is the first step toward the policy rate influencing other interest rates in the economy.
As part of the payment system, banks have accounts in Norges Bank. Banks’ overnight deposits in Norges Bank are referred to as central bank reserves or just reserves.
Throughout the day, banks’ customers (households and firms) transfer money to each other. Banks settle payments to each other by transferring funds between their accounts in Norges Bank. When banks receive a customer deposit, banks’ deposits are increased in Norges Bank. When banks lose a customer deposit, banks’ deposits are reduced in Norges Bank.
Owing to transfers between banks’ accounts in Norges Bank throughout the day, some banks may have substantial reserves on their books at the end of the day, while other banks may have little reserves or negative account balances. Varying interest rates are also part of the picture.
A quota-based system
Norway has a quota-based system for banks’ deposits and loans in Norges Bank based on three different rates:
- The policy rate: the rate banks receive on their overnight deposits in Norges Bank up until a certain amount, ie a quota.
- The reserve rate: the rate banks receive on their overnight deposits in Norges Bank in excess of their quota. The reserve rate is normally lower than the policy rate (currently 1 percentage point lower).
- The D-loan rate (overnight lending rate): the rate banks have to pay if they have negative account balances in Norges Bank at the end of the day and have to borrow extra reserves overnight from Norges Bank (against collateral). Banks have to borrow sufficient reserves to ensure a zero balance on their accounts. The D-loan rate is normally above the policy rate (currently 1 percentage point higher).
Banks redistribute reserves among themselves during the night
Banks aim to have the highest possible rate on their deposits. They wish to avoid having deposits overnight in Norges Bank at the reserve rate and then borrowing overnight at the D-loan rate. Banks avoid this by borrowing reserves from each other at the end of the day.
Banks with deposits in excess of the quota lend to banks that have negative account balances or deposits below the quota. Banks with negative account balances borrow reserves from banks with positive account balances.
By redistributing reserves among themselves, banks can hold deposits in Norges Bank within the quota, with the result that no bank has to deposit reserves overnight at the reserve rate or borrow overnight at the D-loan rate.
The overnight redistribution of reserves between banks is referred to as the overnight market in the interbank market, and the rate is referred to as the overnight rate. The overnight rate normally lies between the reserve rate and the overnight loan rate, ie close to the policy rate.
Other rates in the economy, such as interest rates on loans to households and firms, are determined by the prevailing policy rate/overnight rate and expected policy rate/overnight rate, in addition to market risk premiums.
Norges Bank controls the size of banks’ total deposits
Banks’ total deposits in Norges Banks vary from day to day, primarily because payments are made to and from the Norwegian government. When the government makes payments to households and firms, these payments are made through the banking system, resulting in increased bank deposits in Norges Bank (more central bank reserves). When households and firms make payments to the government, bank deposits are reduced in Norges Bank.
Norges Bank aims to keep banks’ total deposits (total reserves) at a certain level, which is lower than the banks’ total quotas. Market operations are used to do this. Most importantly, Norges Bank provides the banks with central bank reserves through so-called F-loans, and deducts reserves through F-deposits.