The Policy Rate Corridor and Bank Reserves

A central bank announces a target interest rate, but it doesn't set that rate by decree the way a store sets a price tag — the actual rate at which banks lend each other money overnight is determined by supply and demand among thousands of banks. So how does the announced target actually become the real rate banks trade at? The answer is a mechanism called the rate corridor, built from two other rates the central bank fully controls.

Floor and ceiling

Banks hold reserve balances at the central bank, and the central bank pays interest on those balances — call this the deposit rate or interest on reserves. No bank will lend to another bank overnight for less than it could earn risk-free by simply parking the money at the central bank, so this rate acts as a floor under the market rate. At the other end, the central bank offers a standing lending facility: any bank can always borrow from the central bank directly, at a rate somewhat above target, if it's short of cash. No bank will pay more than that to borrow from another bank when the central bank itself will lend at that rate, so this acts as a ceiling. The actual overnight market rate gets squeezed between these two — the "corridor" — and the central bank sets its target rate somewhere inside it, adjusting the corridor's width and level to steer where the market rate settles.

A concrete example

Suppose the deposit rate is 5.00% and the standing lending rate is 5.50%, with a policy target of 5.25%. A bank with spare cash won't lend overnight to another bank below 5.00% (it would just keep the cash on deposit instead), and a bank needing cash won't pay above 5.50% (it would just borrow from the central bank directly). Every private overnight loan between banks gets negotiated somewhere inside that 5.00%–5.50% band, and with enough reserves sloshing around the system, competition among banks tends to pull the actual traded rate toward the 5.25% target in the middle.

What this means in practice

The corridor system is why a central bank can hit its target rate with precision without literally forcing every single bank transaction — it only needs to set two rates it directly controls and let ordinary bank self-interest do the rest. It also explains why the level of reserves in the banking system matters: when reserves are abundant, the rate tends to sit calmly near the floor; when reserves become scarce (say, after a central bank shrinks its balance sheet), the rate can drift up toward the ceiling and become more volatile, which is exactly the kind of plumbing issue that shows up as unexpected stress in short-term funding markets.