The Riksbank’s ability to steer interest rates in the economy derives from its capacity to set the interest rate at which an institution deposits or borrows funds overnight at the Bank. This interest rate is called the overnight rate. By steering the overnight rate the Riksbank influences short-term market rates. Simplifying somewhat, short-term market rates should follow the expected path of the overnight rate. All other things being equal, a higher level of interest rates tends to subdue activity in the economy and thereby ease inflationary pressures, and vice versa.
The Riksbank has several instruments for steering the overnight rate.
- Firstly the Riksbank provides standing facilities that enable banks to borrow or deposit funds overnight at the Bank. The rate of interest that a bank receives when depositing funds overnight at the Riksbank is the Riksbank’s deposit rate. Correspondingly, a bank that borrows funds overnight from the Riksbank must pay interest at the Riksbank’s lending rate. The deposit rate is the "floor" of the interest rate corridor and is 0.75 percentage points lower than the repo rate. Likewise, the lending rate is the "ceiling" of the corridor and is 0.75 percentage points higher than the repo rate. The overnight rate will always be within the interest rate corridor since a bank in need of liquidity can always borrow funds from the Riksbank at the lending rate while a bank with surplus liquidity can always deposit this surplus at the Riksbank at the deposit rate. As there is a difference between these two rates, banks have an incentive to agree on a rate of interest that lies between the rates received or paid by the banks at the Riksbank.
- Secondly the Riksbank uses the repo rate as its key signalling rate. With this rate the Riksbank indicates what the overnight rate will be one week ahead. It is the Executive Board of the Riksbank that makes decisions regarding the repo rate. A repo, or repurchase agreement, is a transaction in which a party sells/buys a security and simultaneously agrees to repurchase/resell it after a specified time. If there is a liquidity deficit in the banking system, the Riksbank supplies funds by buying securities through weekly repos. In the event of a liquidity surplus the Riksbank issues Riksbank certificates. The banking system as a whole has a liquidity deficit at present.
- Thirdly the Riksbank conducts fine-tuning operations on a daily basis with the aim of stabilising the overnight rate. This is achieved by allowing banks to borrow/deposit funds at the Riksbank at the repo rate plus/minus 0.1 percentage points, depending on whether there is an overall surplus or deficit vis-à-vis the Riksbank. This holds the overnight rate within a narrower band than the interest rate corridor and helps to make monetary policy signalling clearer.