How Central Banks Set Interest Rates (and why it’s called the “overnight rate”)
Interest rates are one of those topics everyone hears about, but few people really understand how they actually work. With both the Bank of Canada (BoC) and the US Federal Reserve (the Fed) recently announcing that they were holding their policy rates steady, it felt like a good time to step back and look at what these rates actually are – and how they’re set.
The Overnight Rate
When we hear that the BoC or the Fed “sets interest rates,” what they’re really setting is a target overnight rate. It’s called the overnight rate – sometimes referred to as the benchmark rate – because it applies to very short-term loans, literally overnight, between major financial institutions. Think large banks lending to one another to make sure they have enough cash on hand at the end of each business day, such as TD Bank (TSE: TD) lending to the Royal Bank of Canada (TSE: RY).
Interest rates don’t move in isolation — they flow from the central bank to banks, and then to consumers and businesses.
Central banks don’t lend money directly to consumers or businesses. Instead, they influence the economy by controlling the cost of money for banks, and that cost then works its way through the entire financial system.
At the end of each day, some banks have extra cash on hand, while others come up short due to withdrawals, loan activity, or settlement requirements. Banks that are short can borrow from other banks overnight to balance their books. The central bank sets a target rate (in Canada) or a target range (in the US) for these overnight loans and keeps the market rate trading close to that level by standing ready to lend to, or accept deposits from, banks at closely related rates.
If a bank can’t borrow from another bank, it can borrow directly from the central bank as a backstop. In Canada, this happens through the Standing Liquidity Facility, while in the US it’s done through the discount window. These loans are typically priced slightly above the overnight target, which encourages banks to borrow from each other first rather than leaning on the central bank.
Those target rates aren’t adjusted on a whim. Central banks base their decisions on a steady stream of economic data, with inflation and economic growth doing most of the heavy lifting. If prices are rising too quickly, rates may be raised to cool borrowing and spending. If the economy is slowing or showing signs of stress, rates can be lowered to encourage lending and investment. When inflation is moving in the right direction and the economy is holding up reasonably well, rates are often left unchanged. At its core, the goal is to strike a balance between keeping inflation under control and avoiding unnecessary economic pain.
In simple terms, banks lend to each other overnight, the central bank controls the price of that borrowing, and that price is what we call the overnight rate.
The Prime Rate
This is where interest rates start to matter for the rest of us. Banks use the overnight rate as the foundation for all other lending rates, including the prime rate – the benchmark that affects variable-rate mortgages, lines of credit, and some business loans. Credit cards, auto loans, and other borrowing rates are built on top of that same foundation. If you’ve ever dealt with a bank or other financial institution, you’ve almost certainly heard the term “prime.”
In Canada, the prime rate usually sits a couple of percentage points above the overnight rate. So when the BoC raises or cuts its policy rate, banks tend to adjust their prime rates almost immediately – and that’s when borrowers really start to feel the impact.
Why does this matter?
Central banks aren’t setting mortgage or loan rates directly – but they do set the cost of money between banks, and that cost ripples through the entire economy. Higher overnight rates make borrowing more expensive, slow spending, and cool economic growth; lower rates do the opposite. That’s why decisions from the BoC and the Fed matter so much – even if they feel far removed from your day-to-day finances.
Now that you have a high-level understanding of interest rates and how the central bank, banks, and consumers are all connected, let’s see how this week’s rate decisions affected the markets – and what else moved things over the past week.
Items that may only interest or educate me ….
A New Fed Leader?, Canadian Economic news, US Economic news, ….
A New Fed Leader?
President Donald Trump announced that he has nominated Kevin Warsh, a former Federal Reserve governor, to be the next chair of the US central bank, replacing Jerome Powell when his term ends in May. The announcement ends months of speculation and signals the administration’s desire for a clear shift in direction at the Fed.
Warsh, 55, served on the Fed’s Board of Governors from 2006 to 2011 and played a key role during the global financial crisis. Appointed at just 35, he remains the youngest person ever to serve on the Fed’s board and was also a finalist for the chair role in 2017 before Trump ultimately selected Powell. Known for his market-focused approach and deep experience with financial markets and large banks, Warsh was once viewed as favouring higher interest rates to keep inflation in check. More recently, however, his public comments suggest he has shifted toward supporting lower and faster rate cuts, along with criticizing the Fed for relying too heavily on backward-looking data. Those views align more closely with President Trump’s push for a more aggressive change in monetary policy.
The nomination now moves to the Senate, where Warsh must clear a confirmation hearing before the Senate Banking Committee and a full floor vote. If confirmed, he would take over in May 2026 and face the challenge of leading the Fed as it balances its dual mandate of price stability and maximum employment, while operating in a political environment that has been openly critical of the central bank’s independence.
Reaction from analysts and investors has been mixed. Some see Warsh’s experience as reassuring, especially given his crisis-era background, and view him as a “safe” choice who understands how financial markets and big banks operate. Others worry the nomination could make the Fed appear more influenced by politics and less independent. A loss of confidence in the Fed’s independence could increase uncertainty around interest rates, inflation, and market volatility. If confirmed, Warsh would step into the role at a pivotal moment, with inflation, rates, and future rate cuts firmly in focus.
Canadian Economic news
This past week’s key economic data that the Bank of Canada (BoC) considers when deciding whether to raise or lower the interest rate.
Bank of Canada Rate Decision
As expected, the Bank of Canada kept its benchmark rate unchanged at 2.25%, marking the second straight meeting with no move. The central bank signalled a continued wait-and-see approach, noting that inflation is tracking close to its 2% target while economic uncertainty is still elevated. As Governor Tiff Macklem put it, “elevated uncertainty makes it difficult to predict the timing or direction of the next change in the policy rate.” With growth showing signs of softening and global risks still in play, the BoC appears comfortable staying on hold rather than rushing into further rate moves.
The Bank explained that maintaining the rate reflects its view that policy is appropriately balanced for where the economy stands today. Inflation is expected to remain near target, while growth is slowing but not falling off a cliff. At the same time, uncertainty around external risks – including US policy decisions and the upcoming Canada-US-Mexico Agreement review – makes the path forward less predictable. For now, the BoC seems content to wait for clearer signals before making its next move.
Gross Domestic Product (GDP)
According to Statistics Canada, the Canadian economy stalled in November, with real GDP coming in flat after a 0.3% decline in October. Economists had been expecting a modest 0.1% increase, so the report came in slightly softer than hoped. On a year-over-year basis, the economy is still growing, but only by 0.6%, highlighting just how sluggish overall momentum has become.
Under the hood, weakness in goods-producing industries was the main drag. That side of the economy fell 0.3% in November, driven largely by a sharp 1.3% drop in manufacturing. Utilities were a bright spot, rising 0.6%, but not enough to offset broader declines. Over the past year, manufacturing activity is down 4.9%, while agriculture, forestry, fishing, and hunting has been a standout, up 7.1%. On the services side, modest growth of 0.1% helped cushion the blow. Retail sales rose 1.3% from October and are up 2.7% from a year ago, while wholesale trade fell 2.1% month over month. Meanwhile, management of companies and enterprises showed notable weakness, declining 21.1% from a year earlier.
Overall, the report suggests the Canadian economy lost steam heading into the year end. Stronger consumer activity is helping, but it continues to be weighed down by soft manufacturing and trade. That mix helps explain why the BoC has been comfortable keeping interest rates unchanged. Early estimates point to a small 0.1% GDP increase in December, but even with that, many analysts believe the economy likely contracted in the fourth quarter of 2025, a sharp slowdown from the solid growth seen in the third quarter.
Canadian Market Volatility
Canada’s “fear gauge,” the VIXC (tracked by the VIXI), opened the week at 14.82 after President Trump threatened tariffs of up to 100% on Canadian goods. With no major economic surprises through most of the week, the index gradually drifted higher toward the 16 level as geopolitical tensions continued to simmer. Volatility spiked sharply by Friday’s close, with the VIXC jumping to 19.34. That move followed President Trump’s threat to decertify all Canadian-made aircraft and impose 50% tariffs on new Canadian planes, along with renewed uncertainty tied to his nominee to lead the Fed. Unsurprisingly, markets don’t react well to uncertainty.
Think of the VIXC as Canada’s market mood ring. Readings near 20 suggest anxiety is starting to creep in – investors are becoming more defensive, risk appetite is fading, and markets are more sensitive to bad news. It’s not outright panic, but it does signal a shift from cautious confidence to growing unease.
US Economic news
This past week’s key data points that the Federal Reserve (Fed) considers when deciding whether to raise or lower the interest rate.
Federal Open Market Committee (FOMC) Rate Decision
Following the conclusion of its two-day FOMC meeting, Fed Chair Jerome Powell announced that the central bank would keep its benchmark interest rate unchanged in the 3.50% to 3.75% range. This was the Fed’s first rate pause since July 2025, after delivering three consecutive rate cuts to close out last year. The decision was widely expected by markets and reflects policymakers taking stock of mixed economic signals.
In its post-meeting statement, the Fed noted that economic activity continues to expand at a solid pace, while the labour market is showing signs of stabilizing. At the same time, inflation remains somewhat above the Fed’s 2% target. That combination led most FOMC members to hold rates steady rather than move into another cut just yet.
The decision was not unanimous, however, with two members voting in favour of a further rate cut. Still, the majority opted to stay on hold, reinforcing the Fed’s data-dependent, wait-and-see approach rather than moving aggressively in either direction.
In practical terms, this means short-term US borrowing costs tied to the federal funds rate remain stable for now. Markets will be watching upcoming inflation and labour reports closely for clues about the Fed’s next move, with many analysts currently expecting two rate cuts sometime in 2026.
Consumer Confidence Index (CCI)
The Conference Board’s Consumer Confidence Index (CCI) for January fell sharply to 84.5, its lowest level since May 2014, including the COVID-19 years. After a slight improvement in December, American consumer confidence resumed its downward slide. That’s a steep drop from December’s upwardly revised 94.2 and well below expectations. Overall, it’s a clear signal that consumers are feeling the pressure from persistent inflation, a cooling labour market, and rising economic uncertainty.
The Present Situation index, which reflects views on current business conditions and the job market, slipped to 113.7. While this is still above the headline index, it shows that confidence in today’s economy is starting to fade. The bigger concern lies with the Expectations index, which tracks the outlook for the next six months and fell to 65.1. That’s a historically weak reading and marks twelve straight months below the 80 level, often viewed as a recession warning line, pointing to growing pessimism about the future.
Analysts had been expecting the CCI to come in around the 90 level, so the drop to 84.5 was a significant miss and added to concerns that consumer confidence is deteriorating faster than anticipated. Confidence weakened across the board in January, but expectations for the future deteriorated the most, and that’s the part markets tend to watch closely. A cautious consumer is more likely to pull back on spending, which can ultimately weigh on economic growth.
American Market Volatility
The CBOE Volatility Index (VIX), often called the market’s “fear gauge,” opened the week at 16.42, slightly above where it closed the previous week. It spent most of the week hovering around the 16 level before briefly jumping to 19.5 after weekly jobless claims came in higher than expected. Once investors had time to digest the data, the spike faded quickly, with the VIX slipping back below 17. By Friday, volatility ticked higher again, ending the week at 17.59 following President Trump’s announcement that Kevin Warsh would be his nominee to lead the Fed.
Think of the VIX as the market’s pulse. After a brief spike, volatility settled back to more moderate levels by week’s end. Investors are clearly more cautious than they were earlier in the month, but the VIX remaining below 20 suggests there’s concern, not panic. Markets are still trying to balance questions around interest rates, inflation, and the Fed’s next moves, but investors are not rushing for the exits.
Weekly Market and Portfolio Review
For the week, the TSX (SPTSX) plunged 3.7%, the S&P 500 (SPX) rose 0.3%, the DJIA (INDU) fell 0.4% and the Nasdaq (CCMP) slipped 0.2%.
| Index | Weekly Streak |
| TSX: | 1 – week losing streak |
| S&P: | 1 – week winning streak |
| DJIA: | 3 – week losing streak |
| Nasdaq: | 3 – week losing streak |
Expectations were high going into the last week of January, with rate decisions on both sides of the border and the first of the Magnificent 7 companies set to report fourth-quarter earnings. The week started on a positive note but quickly turned challenging. By Friday, the Toronto Stock Exchange Composite Index (TSX), the Dow Jones Industrial Average (DJIA), and Nasdaq Composite Index (Nasdaq) had all lost ground, while the S&P 500 Index (S&P) managed a modest gain. Before the pullback, the Nasdaq extended a six-day winning streak, and the S&P climbed for five sessions in a row, briefly topping 7,000. In Canada, the TSX hit an intraday record early in the week before plunging into negative territory by Friday.
In the US, markets were largely driven by three forces: technology earnings, the Fed, and investor reactions to mixed corporate results. Early in the week, optimism around upcoming earnings from technology giants like Apple (NASD: AAPL) and Microsoft (NASD: MSFT) lifted the S&P, DJIA, and Nasdaq. A rally in chipmakers, fueled by strong demand for artificial intelligence (AI) and data-centre hardware, added to the upbeat sentiment. Gold briefly topped US$5,500 per ounce, and silver climbed above US$120 before giving back some gains.
Midweek, attention shifted to the Fed, which held its benchmark rate steady at 3.50%–3.75%. The move was widely expected and helped calm markets, reinforcing the Fed’s data-dependent “wait and see” stance after three consecutive rate cuts. Investors continued to speculate on how many rate cuts might come later in 2026.
Later in the week, corporate earnings dominated the headlines. Magnificent 7 member Microsoft’s results showed higher-than-expected AI investment costs alongside slower cloud growth, reigniting lingering concerns about AI spending. Shares fell more than 10% the next day, finishing the week down roughly 7%, and the broader technology sector pulled back as well, weighing on the Nasdaq and S&P.
On Friday, markets reacted to President Trump’s announcement that he had nominated former Fed governor Kevin Warsh as the next central bank chair. Investors had hoped for a more aggressively dovish pick to accelerate rate cuts, so Warsh’s nomination, viewed as more conventional, tempered expectations for near-term interest rate cuts.
In Canada, the TSX started the week strong, lifted by commodities. Gold and silver hovered near record highs, boosting mining stocks, while energy names benefited from firmer oil prices amid heightened US-Iran tensions. Central bank decisions from both the BoC and the Fed came in as expected, offering some stability, but investors grew cautious after data showed Canada’s international trade deficit widened sharply in November, largely due to a drop in merchandise exports tied to American tariffs. Exports to the US fell to 68% of total exports, down from 76% a year earlier, underscoring the impact of tariffs.
By week’s end, caution turned to a rout. Weak earnings from American technology giants weighed on Canada’s technology sector, triggering a sell-off in AI-linked stocks. Adding to the pressure, President Trump threatened to decertify “all Aircraft made in Canada” and impose 50% tariffs on new Canadian-made planes until Canada certified the latest aircraft produced by US rival Gulfstream. A pullback in precious metal prices, including gold’s biggest daily drop since the early 80’s and silver’s biggest daily decline on record, as investors took profits further drove the TSX lower, leaving the index down sharply heading into the weekend.
Overall, it was a volatile week full of ups and downs. Early optimism over the potential of strong earnings from technology giants and soaring commodity prices gave way to market jitters, driven by AI disappointments, a pullback in metals, ongoing trade tensions, and news about the Fed’s next chair.
| Portfolio | Weekly Streak |
| Portfolio 1: | 3 – week losing streak |
| Portfolio 2: | 1 – week losing streak |
| Portfolio 3: | 3 – week losing streak |
The week started on a promising note, but by the end, all three portfolios had slid into the red, echoing the broader market’s volatility. Portfolio 1 held up the longest, but the TSX’s late-week plunge dragged everything down. To paraphrase Marvin the Martian, “Not a good week, not a good week at all!”
Portfolio 1 was the best of a bad lot, losing ‘just’ 1.7% over the week. Only 32% of its holdings finished higher, but most importantly, its largest position, Nvidia (NASD: NVDA), was among them. Without Nvidia’s gain, the losses could have been much steeper. Cameco (TSE: CCO) hit a record high early in the week before giving back some ground. Pulling the portfolio down were sharp drops from The Trade Desk (NASD: TTD) down 15%, Navitas Semiconductor (NASD: NVTS) down 13%, and Constellation Software (TSE: CSU) down 11%.
Portfolio 2 shed 2.0% of its value, despite having the highest percentage of winners – 46% of its companies gained value. Energy names, including TC Energy (TSE: TRP), which reached a new high, helped cushion the blow. Still, big declines in technology names, like Take-Two Interactive Software (NASD: TTWO) which slipped 10%, outweighed the gains.
Portfolio 3 had the roughest week, falling 2.3%. Nvidia, which had dragged this portfolio down last week as the largest holding (35%), helped limit the loss this time with its positive performance. Overall, 22% of the holdings finished higher. The biggest decline was Lithium Americas (TSE: LAC), which plunged 27%, keeping the overall performance in check.
All in all, it was a tough week for the portfolios, reflecting the broader market’s ups and downs. All three felt the drag from AI jitters and global tensions, though energy names helped cushion the blow. It wasn’t the week I’d hoped for, but most of the moves were short-term swings rather than shifts in the fundamentals. I’ll chalk this week up to ‘market noise’ and head into Monday hoping for a better week for the markets.
Companies on the Radar
After a busy couple of weeks of comings and goings on my radar, it was nice to have a relatively quiet week. The only change this time around was removing Bloom Energy (NYSE: BE) from the list after running it through my Quick Test filter, which produced mixed results.
Bloom’s strengths sit mainly in clean energy infrastructure and distributed power, including some exposure to powering AI data centres, alongside recent revenue growth. That said, the fundamentals are less consistent, with uneven profitability, and volatile cash flows. Bloom Energy is a good example of how the AI theme is extending beyond chips and software into the companies that help power energy-hungry AI data centres. For me, I already have plenty of exposure to the AI trend through the technology names across my three portfolios, and I prefer to focus on businesses that score better than “mixed” in my Quick Test.
With Bloom Energy being dropped from the radar, my radar list is down to six companies.
- GE Aerospace (NYSE: GE): This is the large American aviation and defence business that remained after General Electric split into three separate companies in 2024. It has been on a strong run thanks to high demand for commercial jet engines as global air travel continues to recover. The company focuses on aircraft propulsion systems and services for both commercial and military customers, and it’s also moving into drones. As a global leader in jet engines and aircraft systems, GE Aerospace offers exposure to long-term trends in travel, defence spending, and emerging aviation technology.
- Dutch Bros Inc. (NYSE: BROS): A rapidly expanding drive-thru coffee chain in the US, known for its energetic customer service and customizable drinks. The company is aiming to open at least 160 new locations by the end of 2025 and has long-term goals of surpassing 2,000 stores. Strong brand loyalty, especially in the Western US, makes this an interesting high-growth story – though still in an aggressive build-out phase.
- Xylem Inc. (NYSE: XYL): This is a large American company that develops water technology focused on moving, treating, and managing water. Its products and services are used by utilities, industrial customers, and municipalities for everything from clean drinking water and wastewater treatment to flood control and leak detection. With aging water infrastructure and more frequent climate challenges like droughts and flooding, demand for Xylem’s solutions remains strong. The business offers exposure to long-term, essential infrastructure spending tied to water scarcity, sustainability, and smarter cities.
- Broadcom (NASD: AVGO): A large cap American company that sells semiconductors and software globally. It designs critical chips used in data centres, networking equipment, and broadband infrastructure, playing a behind-the-scenes role in cloud computing and AI. Broadcom also owns a growing enterprise software business following its acquisition of VMware, giving it exposure to both hardware and software spending tied to AI and cloud growth.
- Napco Security Technologies, Inc. (NASD: NSSC): A small US company that provides security hardware and systems like smart locks, intrusion alarms, fire alarms, and access control solutions. It sells through a network of distributors and installers, and has been increasing its recurring service revenue – something investors usually like to see. As demand for security and smart home products grows, Napco has multiple avenues for expansion.
- Lumentum Holdings (NASD: LITE): A large cap US-based optical technology company that makes key components used to move data at extremely high speeds across cloud and data-centre networks. Products like electro-absorption modulated lasers (EMLs) are seeing rising demand as AI workloads require faster and more efficient connections between servers. As large cloud providers continue ramping up AI infrastructure spending, Lumentum has emerged as a key beneficiary of this next wave of data and connectivity growth.
As always, these are not buy recommendations. Make sure to do your own research and choose investments that fit your personal financial goals.
The Radar Check was last updated January 30, 2026.
Portfolio Update
Portfolio 3
Sold: Covered Call of Nvidia shares: Over the last few months, you may remember me mentioning that Nvidia makes up a large chunk – about 35% – of Portfolio 3. When a single stock carries that much weight, it adds extra risk: if Nvidia drops, it can drag the whole portfolio down (which it has done a few times ☹). This week, I finally acted – or at least set the wheels in motion. To limit the outsized influence of this one stock, I decided to trim my position and sell some shares once the price hits $200.
Instead of placing a regular sell order, I used a covered call. This means I sold someone the right to buy my shares at $200 by a certain date and collected the premium upfront. If Nvidia hits $200, the shares are sold at my target price, and I keep the premium as extra income. If it doesn’t, I keep both my shares and the premium. Either way, it’s a simple, low-risk way to reduce my exposure while generating a bit of extra income for the portfolio — a good way to manage risk and optimize long-term returns. 😊
Quick refresher: A covered call is an options strategy where you sell a call option on shares you already own. You collect a premium upfront, and if the stock reaches the agreed price, your shares are sold at that level. If it doesn’t, you keep both the shares and the premium.
That’s a wrap for this week, thanks for reading – may your portfolio stay green and your dividends steady. See you next time!