How a policy rate reaches an overnight funding market

Nothing compels one institution to lend to another at the policy rate. There is no rule and no penalty. The target holds because the policymaker stands on both sides of the market with two prices of its own, and no participant with access will trade outside them.

The floor is the rate the policymaker pays on reserves left with it overnight. No institution will lend to a private counterparty below that figure, because an alternative with no counterparty risk pays more. The ceiling is the rate at which the policymaker lends against good collateral. No institution will borrow above it, because a cheaper source is standing open. The band between the two is the corridor, and the market rate lives inside it by arithmetic rather than by instruction.

Illustratively, a corridor might run from a 4.15 percent floor to a 4.65 percent ceiling, fifty basis points wide. Observed fixings across five consecutive days could be 4.33, 4.31, 4.32, 4.34 and 4.36, averaging 4.332 percent. The range actually used is five basis points — one tenth of what the corridor permits.

This is why the base of your borrowing cost does not wander. Between decisions the overnight leg is close to constant, varying by a basis point or two. So when the rate on a facility changes in a month with no decision in it, the overnight market is almost never the explanation. The cause is somewhere further along the chain: the construction of the term index, the reset convention, or the spread.