Description
The purpose of this study is to contrast the discount and the Fed funds rates since 1990 and
the variables that influence these rates. On the basis of quarterly data, since 1990, the primary
determinants of the two policy rates are: the rate of inflation, the unemployment rate and rates on US
Treasury securities, i.
Journal of Financial Economic Policy
Market vs. administered Federal Reserve policy rates
David Walker
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To cite this document:
David Walker , (2014),"Market vs. administered Federal Reserve policy rates", J ournal of Financial
Economic Policy, Vol. 6 Iss 4 pp. 331 - 341
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Market vs. administered Federal
Reserve policy rates
David Walker
McDonough School of Business, Georgetown University,
Washington, DC, USA
Abstract
Purpose – The purpose of this study is to contrast the discount and the Fed funds rates since 1990 and
the variables that infuence these rates. On the basis of quarterly data, since 1990, the primary
determinants of the two policy rates are: the rate of infation, the unemployment rate and rates on US
Treasury securities, i.
Design/methodology/approach – Ordinary least squares models are developed with
autocorrelation removed.
Findings – 12 per cent level in the Fed funds market rate models. The statistical signifcance of the
coeffcient of the spread between long-termand short-termTreasury rates is a projection of a recession
one year in the future. The statistical signifcance of the coeffcients for unemployment, one and two
quarter the autocorrelation coeffcients, adjusted R-square values and Durbin-Watson statistics are
similar for the two policy rate models.
Research limitations/implications – The major limitation is that monthly data are not available
for further tests.
Practical implications – The two Fed policy rates respond differently to the impacts of infation,
unemployment and yield curve tilts.
Social implications – Expected recessions, refected by the yield curve are not often anticipated.
Originality/value – The approach and results have a different perspective from the work in most
studies involving Federal Reserve policy rates.
Keywords Infation, Financial markets and the macroeconomy, Central banks and their policies,
Fed policy, Fed fund rate, Discount rates
Paper type Research paper
1. Introduction
Federal Reserve monetary policy for 2013 was full of surprises; 2014 policy is likely to be
somewhat more predictable. The initial months of ChairwomanYellen’s termhave followed
what Bernanke projected, as shown by her February and May Congressional testimonies.
Throughout the frst eight months of 2013, Chairman Bernanke (with Dr Yellen as Fed Vice
Chair) prepared markets, analysts and policymakers for the Fed to taper its purchases of
long-term Treasury and mortgage back securities by the September 2013 Federal Reserve
Open Market Committee (FOMC) meeting. Instead, at the September and November
meetings, the FOMCcontinuedits quantitative easingwithmonthlypurchases of $85billion
in long-term securities – $45 billion in ten-year US government securities (USGs) and $40
JEL classifcation – E58, G28
The author would like to acknowledge the recommendation of an anonymous reviewer for the
journal to clarify difference between the Fed funds market and target rates.
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
Federal Reserve
policy rates
331
Journal of Financial Economic Policy
Vol. 6 No. 4, 2014
pp. 331-341
©Emerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-05-2014-0032
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billion mortgage backed securities. Some aspects of the September and November decisions
were probably a result of the Federal government shutdown and Congressional delays in
negotiating a continuing budget resolution to avoid a default.
Federal Reserve 2013-2014 policies
Finally, after the Congress agreed on a budget, the economy continued to create newjobs
at a consistent rate of nearly 175,000 jobs per month (until December 2013), the rate of
infation remained below the Fed’s two per cent target, and Fed Chair Yellen was
accepted for confrmation, at its December meeting the FOMC decided to “taper” its
government securities purchases from $85 to $75 Billion per month and continues to
taper in 2014. In her initial “Semiannual Monetary Policy Report to the Congress”
(February 11, 2014), Fed Chair Yellen stated that she expects Federal Reserve Monetary
Policy to continue the path that it had followed toward the end of Chairman Bernanke’s
term(Board of Governors of the Federal Reserve Testimony, 2014a), and it has recently
tapered to $35 Billion (Board of Governors of the Federal Reserve Press Release, 2014d)
and is expected to continue tapering. Chairwoman Yellen’s May testimony and her
speech at the International Monetary Fund (IMF) (Yellen, 2014) indicate that no major
Fed policy changes are anticipated for the near future.
This study contrasts the behavior of the Federal Reserve’s administered policy
discount rate with the market Fed funds rate. Since 1990, the two rates have been
correlated at the surprisingly high level of 0.97 and yet, the statistical importance of
infation is different as an expected determinant of the two rates.
Transmissions of changes in the discount rate and the Fed funds rate are very
different. The discount rate is recommended by the FOMC, and each of the 12 Federal
Reserve Banks establishes the rate it charges to eligible borrower institutions
headquartered in its region. Historically, the Reserve Banks charge the discount rate
recommended by the FOMC for loans secured by eligible collateral. Normally, discount
window loans are short term, from one day to a few weeks, except for longer-term
seasonal loans. The discount rate is established to exceed the FOMC target Fed funds
rate, usually by approximately 50 basis points, so that institutions have no incentive to
borrow funds at the discount window and sell them in the Fed funds market.
The Fed funds market rate is the equilibriumrate determined by demand and supply in
the competitive funds market that links the demand for short-term funds by insured
depository institutions that purchase Fed funds and the supply offered by insured
depositories, plusother institutionsauthorizedtosell Fedfunds. TheFOMCtriestoaffect the
equilibriumFed funds rate through its decisions to purchase and sell USGs and the impacts
of other policies on the quantity of Fed funds supplied. Purchases (sales) of USGs infuse
(withdraw) funds into (from) the fnancial markets, which shifts the Fed funds supply curve
slope and/or intercept to the right (left), reducing (increasing) the equilibriumrate.
Framework for the study
The framework for this study is the Fed’s implementation of traditional monetary
policies to infuence both the market Fed funds rate and the administered discount rate
as a reaction to the levels of unemployment, infation and interest rates on USGs.
Hundreds of sophisticated papers have examined the related, but very different issue of
how unemployment, infation and economic growth respond to FOMC monetary policy
decisions and actions over the past 100 years.
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Federal Reserve target levels of unemployment and infation are the results of the
mandates for the Federal Reserve toimplement policyas statedinthe Federal Reserve Act of
1913: “to promote effectively the goals of maximum employment, stable prices, and
moderate long-term interest rates”. The impact of these economic determinants and others
are tested. As the Fed funds rate is a market rate, the transmission of changes in this rate is
mainly via open market operations and other potential Federal Reserve policy adjustments.
Only a small dollar amount of any open market transaction will infuence the Fed funds
market.
Section 2 mentions a narrow portion of the relevant literature. The model is
delineated in Section 3. The characteristics and correlations among the relevant macro
variables are presented in Section 4. Regression models and determinants of the policy
rates are tested in Section 5. The conclusions follow in Section 6.
2. Literature
Goodfriend (1983) and others have analyzed discount window and Fed funds market
behavior in response to Volker’s October 6, 1979 policy change toward reserve targeting
to deal with the 1970s infation (see Silber, 2012, Chapter 10). Goodfriend developed a
bank demand model for funds at the discount window. Almost a decade earlier,
Bernanke and Binder (1992) analyzed what Fed funds rates might refect about future
macro-economic activity. This work preceded numerous papers with a different focus
that suggest inverted yield curves often portray future recessions by approximately one
year (Estrella and Mishkin, 1996; Haubrich, 2006; and Powell, 2006). Adecade before the
recent fnancial crisis, Flannery (1996) examined the unique roles of private and public
credit markets, represented by the discount window, during fnancial crises. Baum and
Karasulu (1997) developed a model to represent Fed discount rate policy since October
1979, considering howinfrequently that rate is changed; it has not changed in the past 14
quarters. Bartolini et al. (2002) present a model explaining the volatility of the Fed funds
market rate as a reaction to Fed policies such as the intervention policies in 1994 and
establishment of interest rates targets.
Following the recent fnancial crisis, Goodfriend (2011) examined the impacts of the
Fed’s purchase of long-term government securities on fscal policy, as it has related to
the Treasury – Federal Reserve Accord, Fed independence, the Fed’s reaction to the
recent fnancial crisis and the 2008 failures of Bear Stearns and Lehman Brothers (see
Kensil and Margraff, 2012; Gaby and Walker, 2011). The potential impacts of the Fed
long-term securities’ purchases on the fscal defcit and possible “crowding out” will be
mentioned below.
The literature abounds with monetary policy studies about central bank
implementation of open market transactions to infuence infation, unemployment,
gross domestic product (GDP) growth and other macro-economic targets. There are
probably even more studies in the past several years of how the Fed has dealt with the
fnancial crisis, subprime mortgage lending and related issues. These issues are
important, but not directly relevant to the models developed in this study.
3. Model
There are surprisingly fewstudies that explain howthe Fed funds market rate, FF, and
the discount rate, DR, an administered rate, have reacted to the macro-economic
333
Federal Reserve
policy rates
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variables the Fed is obligated to attempt to “control” (see Weidenbaum, 1996). This
study attempts to fll that research gap.
Policy approaches and rates
The Fed’s approach to infuence FF is, of course, to employ its policy tools, primarily
open market operations, to buy and sell USGs. Fed policy has probably never been more
transparent than the current one, and the announced gradual tapering of purchasing
long-term government securities. The Fed is assumed to administer the discount rate,
DR, to stimulate the US economy directly in response to unsatisfactory levels of
unemployment, infation and interest rates.
The April and June 2014, FOMC press releases emphasize that current policy will
hardly change until infation begins to rise toward 2.0 per cent (Board of Governors of
the Federal Reserve Press Release, 2014b and 2014d). The June 2014 unemployment rate
declined to 6.1 per cent after some discouraged job seekers’ began seeking employment
and began fnding jobs. The Fed continues to have a Fed funds target rate near 0.25 per
cent. Since June 18, 2014 the policy has been to purchase $20 billion of long-term
Treasury securities and $15 billion of mortgage-backed securities; each of these
purchases had been reduced by $5 billion per month for each security. Fed Chair Yellen
has stated that she expects the FOMC to continue polices that were implemented at the
December 2013, February 2014 and June 2014 meetings (Board of Governors of the
Federal Reserve Testimony and Press Releases, 2014a, 2014c, 2014d); the government
securities’ purchases are likely to end in October (2014d).
The processes by which the Fed and the FOMC infuence the Fed funds market rate
and the discount rate are via its collective policies, P, which can be represented by:
r
j
? f
j
(
P, X
)
j ? 1, 2 (1)
where r
1
? FF, r
2
? DR and X represents a set of exogenous economic factors. The
polices can be represented by a combination of open market operations in US
government securities, ?USG; changes in bank reserve requirements on deposits ?rr;
changes in margin requirements, ?mr; changes in interest rates paid on bank reserves
held with Federal Reserve Banks, ?br and changes in central bank’s application of
moral suasion, ?ms:
P ? g
(
?USG, ?rr, ?mr, ?br, ?ms
)
(2)
Various regulatory stipulations and agreements since 1970 have altered the Fed’s policy
options. Under normal economic circumstances, both ?rr and ?mr have become 0.
The obligation of the Fed is to set policy to pursue full employment, lowinfation and
stable interest rates; U is the unemployment rate, INF is the rate of infation and i
represents interest rates on USGs. Figure 1 portrays some of the linkages among
policies, macro-economic goals and policy rates:
r
j
? h
j
(
U, INF, i, X
)
j ? 1, 2 (3)
The empirical tests, including the exogenous variables represented by X, will include:
fve interest rates – three and six month Treasury Bill rates, the ten-year rate on USGs,
the difference between long-termTreasury securities and each short-termTreasury Bill
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rate. The ten-year rate minus a Treasury Bill rate captures the shape of the USG yield
curve. Potential impacts are tested for real GDP growth, fscal defcits as a percentage of
real GDP, and via binary variables, that represent recession years and potential
leadership differences between the Greenspan and Bernanke. Real GDP indicates where
the economy may be within a business cycle. The fscal defcit’s percentage of GDP is an
indicator of whether the federal government might be “crowding out” private sector
demand for funds.
4. Characteristics of the period
This study has a long run perspective. The data are 96 quarterly observations from1990
through the fourth quarter of 2013. Quarterly data are collected from the St Louis
Federal Reserve Bank FRED2 database.
The period follows the 1987 stock market crash (a decline of 600 points for the Dow
Jones Industrial Average); various periods of strong economic growth; the recessions of
1990, 2001 and 2007-2009 (National Bureau of Economic Research, 2014); and virtually
all of the Fed leadership by Greenspan and Bernanke. Over the 24-year period, USA’s
real GDP grew from under $6 Trillion to $16.7 Trillion and the fnancial markets,
measured by the Dow Jones Industrial Average, expanded approximately 435 per cent,
from 2,800 to 15,000.
Characteristics among policy rates and the economy
Table I delineates the diverse characteristics for the economy over the 24 years for the
study. The variables are defned in Appendix. The wide range for most of the variables
refects this diverse period to examine Federal Reserve rate policies. The 0.97 correlation
between the discount and the Fed funds rate is surprising, as the frst rate is
administered by the Federal Reserve Banks and the other is a market rate transmitted
somewhat through open market operations. The Fed funds rate changes slightly every
day. Over the past 96 quarters, the discount rate has been changed 31 times, but not in
the most recent 14 quarters.
The correlations among levels and changes in the two policy rates are portrayed in
Table II. Rate changes are hardly correlated with the level of the other rate; the
correlation coeffcients between ?DR and FF and between ?FF and DR are both below
0.10. A change in either rate does not appear to be related to the level of the other rate.
The correlation between the changes in the two rates is 0.88 and between the levels of the
two rates is 0.97.
Figure 1.
Policy rate model
335
Federal Reserve
policy rates
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Macro-economic characteristics
The correlation matrix in Table III shows strong relationships among the various
interest rates: the discount rate, the Fed funds rate and three Treasury rates – the
three-month Treasury Bill rate (TB3), the six-month Treasury Bill rate (TB6), and the
ten-year Treasury security rate (T10YR). None of these rates appears to be closely
related to other macro-economic variables. No correlation coeffcient among variables
associated with the components of Figure 1 (U, INF, T10YR) is above 0.50. Other than
correlations among macro variables and various interest rates and costs of funds, the
highest correlation coeffcient in Table III is between the fscal defcit and
unemployment; correlation (DEFICIT,U) ? 0.91. This refects fscal policies the
executive branch employs to deal with high unemployment.
Table I.
Data characteristics
Variables Mean Median SD Maximum Minimum
DR 3.57 3.75 2.01 7.00 0.50
FF 3.46 3.86 2.35 8.25 0.07
U 6.08 5.62 1.62 9.93 3.90
INF 2.70 2.73 1.24 6.23 ?1.63
TB3 3.17 3.56 2.18 7.80 0.01
TB6 3.32 3.61 2.19 7.74 0.05
T10YR 5.11 5.02 1.74 8.70 1.64
GDPGR 2.50 2.80 2.58 7.80 ?8.30
DEFICIT 3.34 3.18 2.79 9.33 ?1.74
GDP 10949 10674 2259 16661 5891
Table II.
Policy rate correlations
Variables ?DR ?FF DR FF
?DR 1.0
?FF 0.88 1.0
DR 0.10 0.08 1.0
FF 0.03 0.03 0.97 1.0
Table III.
Macro-economic
correlations
Variables DR FF TB3 TB6 T10YR DEFICIT NETEX GDPGR U INF
DR 1
FF 0.97 1
TB3 0.95 0.98 1
TB6 0.96 0.99 0.99 1
T10YR 0.75 0.83 0.86 0.87 1
DEFICIT ?0.77 ?0.79 ?0.79 ?0.80 ?0.67 1
NETEX 0.33 0.50 0.52 0.52 0.74 ?0.37 1
GDPGR 0.14 0.15 0.23 0.18 0.19 ?0.23 0.23 1
U ?0.76 ?0.72 ?0.70 ?0.71 ?0.44 0.91 ?0.04 ?0.17 1
INF 0.55 0.51 0.48 0.51 0.48 ?0.34 0.06 ?0.07 ?0.33 1
Means 3.57 3.46 3.17 3.32 5.11 401.77 ?361.15 2.50 6.08 2.70
SD 2.01 2.35 2.18 2.19 1.74 424.54 251.51 2.58 1.62 1.24
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5. Tests and determinants
The correlations in Tables II and III and the conceptualization of the fows in Figure 1
provide a foundation for explaining the two rates. The differences in the manner in
which the two policies are implemented or infuenced suggest possible different
determinants or impacts upon the rates.
The Fed’s mandate from 1913 dictates that the primary determinants of monetary
policy rates should be: the rate of infation (INF), measured here by the GDP defator; the
unemployment rate (U); and long-term interest rates – represented here by the rate on
ten-year Treasury securities (T10YR). The models are conceptualized in Figure 1 and
equation (3).
Primary models
Tables IV and V provide regression results for the two policy rate models; t-statistics
appear on the line directly below the coeffcients. Table IV presents Fed funds rate
models (4.1-4.10), and Table V provides discount rate models (5.1-5.10). At least 97 per
cent of the variation in the rates is explained by the models with one and two quarter
auto-regressive transformations to adjust for serial correlation. The one quarter lag
autocorrelation coeffcients are positive and the two quarter lag coeffcients are
negative, and approximately half the size of the coeffcient for the one quarter lag. The
coeffcients of AR(1) and AR(2) are statistically signifcant in each model. The sumof the
AR(1) and AR(2) coeffcients is positive and approximately 0.95 in each model, except
when the six-month Treasury Bill (TB6) is included, when the sum is 0.82.
Table IV.
FF policy rate regression
models
Model INF U Variable Intercept AR(1) AR(2)
Adjusted R
2
DW
4.1 0.0414 ?0.2445 4.1792 1.6815 ?0.7215 0.98
1.15 ?2.02** 3.98*** 22.54*** ?9.84*** 1.96
4.2 0.0383 ?0.2620 0.0350 YLD3 4.3821 1.6895 ?0.7328 0.98
1.01 ?2.06** 0.45 4.08*** 22.20*** ?9.80*** 1.94
4.3 0.0507 ?0.2842 ?0.4191 YLD6 5.0970 1.6184 ?0.6558 0.99
1.57 ?2.62*** ?5.53*** 5.07*** 18.51*** ?7.60*** 1.84
4.4 0.053 ?0.2152 ?0.2131 REC 4.0000 1.6956 ?0.734 0.98
1.50 ?1.83* ?2.29** 3.83*** 23.15*** ?10.18*** 1.94
4.5 0.0415 ?0.2448 ?0.0021 GDPGR 4.1858 1.6818 ?0.7217 0.98
1.14 ?2.01** ?0.28 3.96*** 22.37*** ?9.76*** 1.96
4.6 0.0438 ?0.2529 0.0003 DEFICIT 4.0930 1.6977 ?0.7356 0.98
1.22 ?2.10** 1.20 3.80*** 23.10*** ?10.17*** 1.94
4.7 0.0459 ?0.2601 0.1199 TB3 3.9031 1.6185 ?0.6621 0.98
1.24 ?2.12** 1.36 3.64*** 19.77*** ?8.23*** 2.04
4.8 ?0.0116 ?0.1111 0.9372 TB6 1.0174 1.0538 ?0.2990 0.99
?0.38 ?1.93** 20.80*** 2.22** 10.17*** ?2.98** 1.93
4.9 0.0330 ?0.2151 0.0773 T10YR 3.691 1.6801 ?0.7220 0.98
0.89 ?1.71* 1.04 3.24*** 21.91*** ?9.55*** 1.99
4.10 0.0420 ?0.2442 ?0.0340 BERN 4.1965 1.6816 ?0.7220 0.98
1.15 ?2.01** ?0.15 3.98*** 22.44*** ?9.80*** 1.96
Notes: *Signifcant at the 10% level; **signifcant at the 5% level; ***signifcant at the 1% level
337
Federal Reserve
policy rates
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The frst model for each rate (4.1 and 5.1, respectively) tests the hypothesis that a policy
rate is explained by only the rate of unemployment (U) and the rate of infation (INF).
The coeffcient of unemployment is negative, indicating falling rates when
unemployment rises, and statistically signifcant to explain each rate. Infation has a
positive coeffcient to explain each rate; however, in the Fed funds rate model, the
t-statistic for the coeffcient of INF is only 1.15, indicating little impact of infation on the
market Fed funds rate.
Alternative models
The explanatory power of additional variables is examined for nine additional models
for each policy rate. The statistically strongest and most interesting case includes a
forward perspective of potential recessions – including YLD3 ?T10YR – TB3 (models
4.2 and 5.2) and YLD6 ?T10YR – TB6 (models 4.3 and 5.3). As constructed here, YLD3
and YLD6 allowfor an inverted yield curve (YLD3 ?0 and YLD6 ?0), which is claimed
to project a future recession approximately one year in advance (see Estrella and
Mishkin, 1996; Powell, 2006; and Haubrich, 2006). An alternative to the models with
YLD3 and YLD6 is to introduce a binary variable to represent the 1990, 2001 and
2007-2009 US recessions (REC), as defned by the National Bureau of Economic
Research (2014). The models with YLD6 are statistically superior, on the basis of the
t-statistics, to the models with the binary recession variable (REC). To test whether the
periods for the Greenspan and Bernanke chairmanships were different, the binary
variable BERN is constructed to equal 1.0 for the later period. There appears to be no
difference in the periods.
Table V.
DR policy rate regression
models
Model INF U Variable Intercept AR(1) AR(2)
Adjusted R
2
DW
5.1 0.1019 ?0.4055 5.2720 1.4608 ?0.5231 0.97
2.06** ?2.70** 4.67*** 15.65*** ?5.70*** 2.27
5.2 0.0785 ?0.3455 0.1812 YLD3 4.7929 1.5749 ?0.6395 0.97
1.59 ?2.20** 1.80* 4.10*** 17.88*** ?7.40*** 2.25
5.3 0.1093 ?0.3712 ?0.5645 YLD6 5.9371 1.271 ?0.3258 0.98
2.41*** ?2.91*** ?5.63*** 5.58*** 12.05*** ?3.08*** 2.14
5.4 0.1065 ?0.4018 ?0.8000 REC 5.2367 1.4560 ?0.5173 0.97
2.12** ?2.66*** 0.59 4.59*** 15.45*** ?5.57*** 2.27
5.5 0.1020 ?0.3996 ?0.0115 GDPGR 5.2663 1.4699 ?0.5312 0.97
2.07** ?2.64*** ?1.09 4.63*** 15.69*** ?5.77*** 2.26
5.6 0.1002 ?0.3926 ?0.0002 DEFICIT 5.3083 1.4520 ?0.5172 0.97
2.01** ?2.56*** ?0.59 4.77*** 15.24*** ?5.54*** 2.26
5.7 0.1164 ?0.3629 0.5459 TB3 3.6629 0.9114 ?0.0897 0.97
2.13** ?3.16*** 6.16*** 3.99*** 8.48*** ?0.82 2.04
5.8 0.0516 ?0.1430 0.7903 TB6 1.6886 1.0322 ?0.2044 0.98
1.27 ?1.55 10.95*** 2.31** 9.78*** ?1.96** 2.05
5.9 0.0937 ?0.3875 0.0864 T10YR 4.8187 1.4518 ?0.5198 0.97
1.84* ?2.51*** 0.86 3.78*** 15.30*** ?5.55*** 2.26
5.10 0.1026 ?0.4049 ?0.0390 BERN 5.2890 1.4614 ?0.5245 0.97
2.05** ?2.68*** ?0.12 4.67*** 15.59*** ?5.69*** 2.27
Notes: *Signifcant at the 10% level; **signifcant at the 5% level; ***signifcant at the 1% level
JFEP
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The models that include YLD6 have superior statistical results to the other models to
explain the Fed funds rate and the discount rate. For models 4.3 and 5.3, the coeffcient
of YLD6 is highly statistically signifcant. Also, for models 4.3 and 5.3 the infation
coeffcient has the highest t-statistic among any of the ten models for each of the two
rates. It is useful to include the difference between long-term and short-term rates to
explain the two policy rates.
The alternative models in Tables IV and V include real GDP growth (GDPGR), the
fscal defcit (DEFICIT), separate short-term and long-term Treasury securities’ rates
(TB3, TB6 and T10YR, respectively), and binary recession and Fed chair variables.
None of these models has statistical characteristics that are as strong as the primary
models (4.1 and 5.1) and the models that include the yield curve with TB6 (4.3 and 5.3).
Including the fscal defcit as a ratio to GDP provides an inferior model. The only
separate Treasury rate variable whose coeffcient is statistically signifcant is the
six-month Treasury bill rate, and in those regression models, the coeffcient of infation
is not different from zero at a meaningful probability level. The economic content of
these other factors, including whether there was a recession or who served as Fed Chair,
appears to be captured within U, INF and YLD6.
It appears that the FMOCis adjusting the discount rate and infuencing the Fed funds
rate in response to unemployment rates, infation rates and the prospect for a future
recession over the 1990-2013 period. Higher infation either leads to or is consistent with
increases in the discount rate, but the Fed funds rate is considerably less affected by
changes in infation. It is not surprising that the impact is stronger on the administered
discount rates. Evidently, the market rates have not reacted signifcantly to infation in
recent decades. This may occur because of the somewhat narrow range of levels of
infation over the 24-year period, 1990-2013. From Table III, the standard deviation of
INFis less than half of its mean. Declines in both policy rates occur when unemployment
increases and yield curves tilt, suggesting a future recession.
6. Conclusions
The predominant variable that explains both the Fed funds market rate and the
administered discount rate is the unemployment rate. There is a statistically signifcant,
inverse relationship between unemployment and each of these policy rates. The
representation of the yield curve has a signifcant negative coeffcient, suggesting that
an expected recession encourages lower policy discount and Fed funds rates. The
impact of changes in the infation rate has a smaller impact on the two policy rates, and
a questionable effect on the Fed funds rate; the impact of infation on setting the discount
rate is signifcant, but not as strong as the impact of unemployment. The coeffcients of
real GDP growth, the fscal defcit and the ten-year Treasury securities’ rate are not
statistically signifcant in determining either policy rate.
References
Bartolini, L., Bertola, G. and Prati, A. (2002), “Day-to-day monetary policy and the volatility of the
fed funds rate”, Journal of Money, Credit and Banking, Vol. 34 No. 1, pp. 137-159.
Baum, C.F. and Karasulu, M. (1997), “Modelling federal reserve discount policy”, Computational
Economics, Vol. 11 Nos 1/2, pp. 53-70.
Bernanke, B.S. and Binder, A. (1992), “The federal funds rate and the channels of monetary
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339
Federal Reserve
policy rates
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the Federal Reserve Press Release, Washington, DC.
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Joint Economic Committee, US Congress, Board of Governors of the Federal Reserve
Testimony, Washington, DC.
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the Federal Reserve Press Release.
Estrella, A. and Mishkin, F.S. (1996), “The yield curve as a predictor of US recessions”, Current
Issues in Economics and Finance, Vol. 2, No. 1.
Flannery, M.J. (1996), “Financial crises, payment system problems, and discount window
lending”, Journal of Money, Credit and Banking, Vol. 28 No. 4, pp. 804-824.
Gaby, M. and Walker, D.A. (2011), “Impacts of TARP on commercial banks”, Journal of Applied
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Goodfriend, M. (1983), “Discount window borrowing, monetary policy, and post-October 6, 1979
federal reserve operating procedure”, Journal of Monetary Economics, Vol. 12 No. 3,
pp. 343-356.
Goodfriend, M. (2011), “Central banking in the credit turmoil: an assessment of federal reserve
practice”, Journal of Monetary Economics, Vol. 58 No. 1, pp. 1-12.
Haubrich, J.G. (2006), Does the Yield Curve Signal Recession?, Federal Reserve Bank of Cleveland,
Cleveland, OH.
Kensil, S. and Margraf, K. (2012), “The advantage of failing frst: Bear Stearns v. Lehman
Brothers”, Journal of Applied Finance, Vol. 22 No. 2.
National Bureau of Economic Research (2014), “Business cycle expansions and contractions”,
available at: www.nber.org.cycles.html (accessed 10 February 2014).
Powell, N. (2006), “What the yield curve does (and doesn’t) tell us”, FYI: An Update on Emerging
Issues in Banking, Federal Deposit Insurance Corporation, Washington, DC.
Silber, W.L. (2012), Volker, Bloomsbury Press, New York, NY.
Weidenbaum, M. (1996), “The employment act of 1946: a half century of presidential
policymaking”, Presidential Studies Quarterly, Vol. 26 No. 3, pp. 880-885.
Yellen, J.L. (2014), “Money policy and fnancial stability”, at the Michel Camdessus Central
Banking Lecture, International Monetary Fund, Washington, DC.
Further reading
Bernanke, B.S. (2014), “The federal reserve: looking back, looking forward”, At the Annual
Meeting of the American Economic Association, Philadelphia, PA.
Board of Governors of the Federal Reserve Press Release (2013a), FOMC, Board of Governors of
the Federal Reserve Press Release, Washington, DC.
Board of Governors of the Federal Reserve (2013b), Supervisory Scenarios for 2014, Board of
Governors of the Federal Reserve, Washington, DC.
Board of Governors of the Federal Reserve (2013c), Discount Window Lending, Board of
Governors of the Federal Reserve, Washington, DC.
Cecchetti, S.G. (2009), “Crisis and responses: the federal reserve in the early stages of the fnancial
crisis”, Journal of Economic Perspectives, Vol. 23 No. 1, pp. 51-75.
JFEP
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Cook, T.Q. (1989), “Determinants of the federal funds rate, 1979-1982”, Federal Reserve Bank of
Richmond Economic Review, Vol. 75, No. 1, pp. 3-19.
Cornett, M.M., McNutt, J.J., Strahan, P.E. and Tehranian, H. (2011), “Liquidity risk management
and credit supply in the fnancial crisis”, Journal of Financial Economics, Vol. 101 No. 2,
pp. 297-312.
Cyree, K.B. and Winters, D.B. (2001), “Analysis of federal funds rate changes and variance
patterns”, Journal of Financial Research, Vol. 24 No. 3, pp. 403-418.
Holmstrom, B. and Tirole, J. (1998), “Private and public supply of liquidity”, Journal of Political
Economy, Vol. 106 No. 1.
Ivashina, V. and Scharfstein, D. (2010), “Bank lending during the fnancial crisis”, Journal of
Financial Economics, Vol. 97 No. 3, pp. 319-338.
Kahn, G.A. and Taylor, L. (2014), “Evolving market perceptions of federal reserve policy
objectives”, Economic Review, Vol. 2014 No. 1, pp. 5-64.
Krueger, J.T. and Kuttner, K.N. (1996), “The fed funds futures rate as a predictor of federal reserve
policy”, The Journal of Futures Markets, Vol. 16 No. 8, pp. 865-879.
US Bureau of Labor Statistics (2014), Employment Situation Summary Economic News Release,
US Bureau of Labor Statistics, Washington, DC.
www.research.stlouisfed.org/Fred2 Federal Reserve Bank of St. Louis Web site
Appendix
Corresponding author
David Walker can be contacted at: [email protected]
To purchase reprints of this article please e-mail: [email protected]
Or visit our web site for further details: www.emeraldinsight.com/reprints
Table AI.
Variable defnitions
Symbol Variable name
DR Discount rate
FF Fed funds rate
U Unemployment
INF Infation
GDPGR GDP growth rate
TB3 three-month treasury bill rate
TB6 six-month treasury bill rate
T10YR ten-year treasury security rate
YLD3 T10YR–TB3
YLD6 T10YR–TB6
NETEX Net exports
DEFICIT Fiscal defcit
REC Recession years: 1990Q3-1991Q1, 2001Q2-2001Q4, 2008Q1-2009Q2
BERN Bernanke Chairmanship 2006 Q1- 2013Q4
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doc_680183775.pdf
The purpose of this study is to contrast the discount and the Fed funds rates since 1990 and
the variables that influence these rates. On the basis of quarterly data, since 1990, the primary
determinants of the two policy rates are: the rate of inflation, the unemployment rate and rates on US
Treasury securities, i.
Journal of Financial Economic Policy
Market vs. administered Federal Reserve policy rates
David Walker
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Market vs. administered Federal
Reserve policy rates
David Walker
McDonough School of Business, Georgetown University,
Washington, DC, USA
Abstract
Purpose – The purpose of this study is to contrast the discount and the Fed funds rates since 1990 and
the variables that infuence these rates. On the basis of quarterly data, since 1990, the primary
determinants of the two policy rates are: the rate of infation, the unemployment rate and rates on US
Treasury securities, i.
Design/methodology/approach – Ordinary least squares models are developed with
autocorrelation removed.
Findings – 12 per cent level in the Fed funds market rate models. The statistical signifcance of the
coeffcient of the spread between long-termand short-termTreasury rates is a projection of a recession
one year in the future. The statistical signifcance of the coeffcients for unemployment, one and two
quarter the autocorrelation coeffcients, adjusted R-square values and Durbin-Watson statistics are
similar for the two policy rate models.
Research limitations/implications – The major limitation is that monthly data are not available
for further tests.
Practical implications – The two Fed policy rates respond differently to the impacts of infation,
unemployment and yield curve tilts.
Social implications – Expected recessions, refected by the yield curve are not often anticipated.
Originality/value – The approach and results have a different perspective from the work in most
studies involving Federal Reserve policy rates.
Keywords Infation, Financial markets and the macroeconomy, Central banks and their policies,
Fed policy, Fed fund rate, Discount rates
Paper type Research paper
1. Introduction
Federal Reserve monetary policy for 2013 was full of surprises; 2014 policy is likely to be
somewhat more predictable. The initial months of ChairwomanYellen’s termhave followed
what Bernanke projected, as shown by her February and May Congressional testimonies.
Throughout the frst eight months of 2013, Chairman Bernanke (with Dr Yellen as Fed Vice
Chair) prepared markets, analysts and policymakers for the Fed to taper its purchases of
long-term Treasury and mortgage back securities by the September 2013 Federal Reserve
Open Market Committee (FOMC) meeting. Instead, at the September and November
meetings, the FOMCcontinuedits quantitative easingwithmonthlypurchases of $85billion
in long-term securities – $45 billion in ten-year US government securities (USGs) and $40
JEL classifcation – E58, G28
The author would like to acknowledge the recommendation of an anonymous reviewer for the
journal to clarify difference between the Fed funds market and target rates.
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
Federal Reserve
policy rates
331
Journal of Financial Economic Policy
Vol. 6 No. 4, 2014
pp. 331-341
©Emerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-05-2014-0032
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billion mortgage backed securities. Some aspects of the September and November decisions
were probably a result of the Federal government shutdown and Congressional delays in
negotiating a continuing budget resolution to avoid a default.
Federal Reserve 2013-2014 policies
Finally, after the Congress agreed on a budget, the economy continued to create newjobs
at a consistent rate of nearly 175,000 jobs per month (until December 2013), the rate of
infation remained below the Fed’s two per cent target, and Fed Chair Yellen was
accepted for confrmation, at its December meeting the FOMC decided to “taper” its
government securities purchases from $85 to $75 Billion per month and continues to
taper in 2014. In her initial “Semiannual Monetary Policy Report to the Congress”
(February 11, 2014), Fed Chair Yellen stated that she expects Federal Reserve Monetary
Policy to continue the path that it had followed toward the end of Chairman Bernanke’s
term(Board of Governors of the Federal Reserve Testimony, 2014a), and it has recently
tapered to $35 Billion (Board of Governors of the Federal Reserve Press Release, 2014d)
and is expected to continue tapering. Chairwoman Yellen’s May testimony and her
speech at the International Monetary Fund (IMF) (Yellen, 2014) indicate that no major
Fed policy changes are anticipated for the near future.
This study contrasts the behavior of the Federal Reserve’s administered policy
discount rate with the market Fed funds rate. Since 1990, the two rates have been
correlated at the surprisingly high level of 0.97 and yet, the statistical importance of
infation is different as an expected determinant of the two rates.
Transmissions of changes in the discount rate and the Fed funds rate are very
different. The discount rate is recommended by the FOMC, and each of the 12 Federal
Reserve Banks establishes the rate it charges to eligible borrower institutions
headquartered in its region. Historically, the Reserve Banks charge the discount rate
recommended by the FOMC for loans secured by eligible collateral. Normally, discount
window loans are short term, from one day to a few weeks, except for longer-term
seasonal loans. The discount rate is established to exceed the FOMC target Fed funds
rate, usually by approximately 50 basis points, so that institutions have no incentive to
borrow funds at the discount window and sell them in the Fed funds market.
The Fed funds market rate is the equilibriumrate determined by demand and supply in
the competitive funds market that links the demand for short-term funds by insured
depository institutions that purchase Fed funds and the supply offered by insured
depositories, plusother institutionsauthorizedtosell Fedfunds. TheFOMCtriestoaffect the
equilibriumFed funds rate through its decisions to purchase and sell USGs and the impacts
of other policies on the quantity of Fed funds supplied. Purchases (sales) of USGs infuse
(withdraw) funds into (from) the fnancial markets, which shifts the Fed funds supply curve
slope and/or intercept to the right (left), reducing (increasing) the equilibriumrate.
Framework for the study
The framework for this study is the Fed’s implementation of traditional monetary
policies to infuence both the market Fed funds rate and the administered discount rate
as a reaction to the levels of unemployment, infation and interest rates on USGs.
Hundreds of sophisticated papers have examined the related, but very different issue of
how unemployment, infation and economic growth respond to FOMC monetary policy
decisions and actions over the past 100 years.
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Federal Reserve target levels of unemployment and infation are the results of the
mandates for the Federal Reserve toimplement policyas statedinthe Federal Reserve Act of
1913: “to promote effectively the goals of maximum employment, stable prices, and
moderate long-term interest rates”. The impact of these economic determinants and others
are tested. As the Fed funds rate is a market rate, the transmission of changes in this rate is
mainly via open market operations and other potential Federal Reserve policy adjustments.
Only a small dollar amount of any open market transaction will infuence the Fed funds
market.
Section 2 mentions a narrow portion of the relevant literature. The model is
delineated in Section 3. The characteristics and correlations among the relevant macro
variables are presented in Section 4. Regression models and determinants of the policy
rates are tested in Section 5. The conclusions follow in Section 6.
2. Literature
Goodfriend (1983) and others have analyzed discount window and Fed funds market
behavior in response to Volker’s October 6, 1979 policy change toward reserve targeting
to deal with the 1970s infation (see Silber, 2012, Chapter 10). Goodfriend developed a
bank demand model for funds at the discount window. Almost a decade earlier,
Bernanke and Binder (1992) analyzed what Fed funds rates might refect about future
macro-economic activity. This work preceded numerous papers with a different focus
that suggest inverted yield curves often portray future recessions by approximately one
year (Estrella and Mishkin, 1996; Haubrich, 2006; and Powell, 2006). Adecade before the
recent fnancial crisis, Flannery (1996) examined the unique roles of private and public
credit markets, represented by the discount window, during fnancial crises. Baum and
Karasulu (1997) developed a model to represent Fed discount rate policy since October
1979, considering howinfrequently that rate is changed; it has not changed in the past 14
quarters. Bartolini et al. (2002) present a model explaining the volatility of the Fed funds
market rate as a reaction to Fed policies such as the intervention policies in 1994 and
establishment of interest rates targets.
Following the recent fnancial crisis, Goodfriend (2011) examined the impacts of the
Fed’s purchase of long-term government securities on fscal policy, as it has related to
the Treasury – Federal Reserve Accord, Fed independence, the Fed’s reaction to the
recent fnancial crisis and the 2008 failures of Bear Stearns and Lehman Brothers (see
Kensil and Margraff, 2012; Gaby and Walker, 2011). The potential impacts of the Fed
long-term securities’ purchases on the fscal defcit and possible “crowding out” will be
mentioned below.
The literature abounds with monetary policy studies about central bank
implementation of open market transactions to infuence infation, unemployment,
gross domestic product (GDP) growth and other macro-economic targets. There are
probably even more studies in the past several years of how the Fed has dealt with the
fnancial crisis, subprime mortgage lending and related issues. These issues are
important, but not directly relevant to the models developed in this study.
3. Model
There are surprisingly fewstudies that explain howthe Fed funds market rate, FF, and
the discount rate, DR, an administered rate, have reacted to the macro-economic
333
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variables the Fed is obligated to attempt to “control” (see Weidenbaum, 1996). This
study attempts to fll that research gap.
Policy approaches and rates
The Fed’s approach to infuence FF is, of course, to employ its policy tools, primarily
open market operations, to buy and sell USGs. Fed policy has probably never been more
transparent than the current one, and the announced gradual tapering of purchasing
long-term government securities. The Fed is assumed to administer the discount rate,
DR, to stimulate the US economy directly in response to unsatisfactory levels of
unemployment, infation and interest rates.
The April and June 2014, FOMC press releases emphasize that current policy will
hardly change until infation begins to rise toward 2.0 per cent (Board of Governors of
the Federal Reserve Press Release, 2014b and 2014d). The June 2014 unemployment rate
declined to 6.1 per cent after some discouraged job seekers’ began seeking employment
and began fnding jobs. The Fed continues to have a Fed funds target rate near 0.25 per
cent. Since June 18, 2014 the policy has been to purchase $20 billion of long-term
Treasury securities and $15 billion of mortgage-backed securities; each of these
purchases had been reduced by $5 billion per month for each security. Fed Chair Yellen
has stated that she expects the FOMC to continue polices that were implemented at the
December 2013, February 2014 and June 2014 meetings (Board of Governors of the
Federal Reserve Testimony and Press Releases, 2014a, 2014c, 2014d); the government
securities’ purchases are likely to end in October (2014d).
The processes by which the Fed and the FOMC infuence the Fed funds market rate
and the discount rate are via its collective policies, P, which can be represented by:
r
j
? f
j
(
P, X
)
j ? 1, 2 (1)
where r
1
? FF, r
2
? DR and X represents a set of exogenous economic factors. The
polices can be represented by a combination of open market operations in US
government securities, ?USG; changes in bank reserve requirements on deposits ?rr;
changes in margin requirements, ?mr; changes in interest rates paid on bank reserves
held with Federal Reserve Banks, ?br and changes in central bank’s application of
moral suasion, ?ms:
P ? g
(
?USG, ?rr, ?mr, ?br, ?ms
)
(2)
Various regulatory stipulations and agreements since 1970 have altered the Fed’s policy
options. Under normal economic circumstances, both ?rr and ?mr have become 0.
The obligation of the Fed is to set policy to pursue full employment, lowinfation and
stable interest rates; U is the unemployment rate, INF is the rate of infation and i
represents interest rates on USGs. Figure 1 portrays some of the linkages among
policies, macro-economic goals and policy rates:
r
j
? h
j
(
U, INF, i, X
)
j ? 1, 2 (3)
The empirical tests, including the exogenous variables represented by X, will include:
fve interest rates – three and six month Treasury Bill rates, the ten-year rate on USGs,
the difference between long-termTreasury securities and each short-termTreasury Bill
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rate. The ten-year rate minus a Treasury Bill rate captures the shape of the USG yield
curve. Potential impacts are tested for real GDP growth, fscal defcits as a percentage of
real GDP, and via binary variables, that represent recession years and potential
leadership differences between the Greenspan and Bernanke. Real GDP indicates where
the economy may be within a business cycle. The fscal defcit’s percentage of GDP is an
indicator of whether the federal government might be “crowding out” private sector
demand for funds.
4. Characteristics of the period
This study has a long run perspective. The data are 96 quarterly observations from1990
through the fourth quarter of 2013. Quarterly data are collected from the St Louis
Federal Reserve Bank FRED2 database.
The period follows the 1987 stock market crash (a decline of 600 points for the Dow
Jones Industrial Average); various periods of strong economic growth; the recessions of
1990, 2001 and 2007-2009 (National Bureau of Economic Research, 2014); and virtually
all of the Fed leadership by Greenspan and Bernanke. Over the 24-year period, USA’s
real GDP grew from under $6 Trillion to $16.7 Trillion and the fnancial markets,
measured by the Dow Jones Industrial Average, expanded approximately 435 per cent,
from 2,800 to 15,000.
Characteristics among policy rates and the economy
Table I delineates the diverse characteristics for the economy over the 24 years for the
study. The variables are defned in Appendix. The wide range for most of the variables
refects this diverse period to examine Federal Reserve rate policies. The 0.97 correlation
between the discount and the Fed funds rate is surprising, as the frst rate is
administered by the Federal Reserve Banks and the other is a market rate transmitted
somewhat through open market operations. The Fed funds rate changes slightly every
day. Over the past 96 quarters, the discount rate has been changed 31 times, but not in
the most recent 14 quarters.
The correlations among levels and changes in the two policy rates are portrayed in
Table II. Rate changes are hardly correlated with the level of the other rate; the
correlation coeffcients between ?DR and FF and between ?FF and DR are both below
0.10. A change in either rate does not appear to be related to the level of the other rate.
The correlation between the changes in the two rates is 0.88 and between the levels of the
two rates is 0.97.
Figure 1.
Policy rate model
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Macro-economic characteristics
The correlation matrix in Table III shows strong relationships among the various
interest rates: the discount rate, the Fed funds rate and three Treasury rates – the
three-month Treasury Bill rate (TB3), the six-month Treasury Bill rate (TB6), and the
ten-year Treasury security rate (T10YR). None of these rates appears to be closely
related to other macro-economic variables. No correlation coeffcient among variables
associated with the components of Figure 1 (U, INF, T10YR) is above 0.50. Other than
correlations among macro variables and various interest rates and costs of funds, the
highest correlation coeffcient in Table III is between the fscal defcit and
unemployment; correlation (DEFICIT,U) ? 0.91. This refects fscal policies the
executive branch employs to deal with high unemployment.
Table I.
Data characteristics
Variables Mean Median SD Maximum Minimum
DR 3.57 3.75 2.01 7.00 0.50
FF 3.46 3.86 2.35 8.25 0.07
U 6.08 5.62 1.62 9.93 3.90
INF 2.70 2.73 1.24 6.23 ?1.63
TB3 3.17 3.56 2.18 7.80 0.01
TB6 3.32 3.61 2.19 7.74 0.05
T10YR 5.11 5.02 1.74 8.70 1.64
GDPGR 2.50 2.80 2.58 7.80 ?8.30
DEFICIT 3.34 3.18 2.79 9.33 ?1.74
GDP 10949 10674 2259 16661 5891
Table II.
Policy rate correlations
Variables ?DR ?FF DR FF
?DR 1.0
?FF 0.88 1.0
DR 0.10 0.08 1.0
FF 0.03 0.03 0.97 1.0
Table III.
Macro-economic
correlations
Variables DR FF TB3 TB6 T10YR DEFICIT NETEX GDPGR U INF
DR 1
FF 0.97 1
TB3 0.95 0.98 1
TB6 0.96 0.99 0.99 1
T10YR 0.75 0.83 0.86 0.87 1
DEFICIT ?0.77 ?0.79 ?0.79 ?0.80 ?0.67 1
NETEX 0.33 0.50 0.52 0.52 0.74 ?0.37 1
GDPGR 0.14 0.15 0.23 0.18 0.19 ?0.23 0.23 1
U ?0.76 ?0.72 ?0.70 ?0.71 ?0.44 0.91 ?0.04 ?0.17 1
INF 0.55 0.51 0.48 0.51 0.48 ?0.34 0.06 ?0.07 ?0.33 1
Means 3.57 3.46 3.17 3.32 5.11 401.77 ?361.15 2.50 6.08 2.70
SD 2.01 2.35 2.18 2.19 1.74 424.54 251.51 2.58 1.62 1.24
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5. Tests and determinants
The correlations in Tables II and III and the conceptualization of the fows in Figure 1
provide a foundation for explaining the two rates. The differences in the manner in
which the two policies are implemented or infuenced suggest possible different
determinants or impacts upon the rates.
The Fed’s mandate from 1913 dictates that the primary determinants of monetary
policy rates should be: the rate of infation (INF), measured here by the GDP defator; the
unemployment rate (U); and long-term interest rates – represented here by the rate on
ten-year Treasury securities (T10YR). The models are conceptualized in Figure 1 and
equation (3).
Primary models
Tables IV and V provide regression results for the two policy rate models; t-statistics
appear on the line directly below the coeffcients. Table IV presents Fed funds rate
models (4.1-4.10), and Table V provides discount rate models (5.1-5.10). At least 97 per
cent of the variation in the rates is explained by the models with one and two quarter
auto-regressive transformations to adjust for serial correlation. The one quarter lag
autocorrelation coeffcients are positive and the two quarter lag coeffcients are
negative, and approximately half the size of the coeffcient for the one quarter lag. The
coeffcients of AR(1) and AR(2) are statistically signifcant in each model. The sumof the
AR(1) and AR(2) coeffcients is positive and approximately 0.95 in each model, except
when the six-month Treasury Bill (TB6) is included, when the sum is 0.82.
Table IV.
FF policy rate regression
models
Model INF U Variable Intercept AR(1) AR(2)
Adjusted R
2
DW
4.1 0.0414 ?0.2445 4.1792 1.6815 ?0.7215 0.98
1.15 ?2.02** 3.98*** 22.54*** ?9.84*** 1.96
4.2 0.0383 ?0.2620 0.0350 YLD3 4.3821 1.6895 ?0.7328 0.98
1.01 ?2.06** 0.45 4.08*** 22.20*** ?9.80*** 1.94
4.3 0.0507 ?0.2842 ?0.4191 YLD6 5.0970 1.6184 ?0.6558 0.99
1.57 ?2.62*** ?5.53*** 5.07*** 18.51*** ?7.60*** 1.84
4.4 0.053 ?0.2152 ?0.2131 REC 4.0000 1.6956 ?0.734 0.98
1.50 ?1.83* ?2.29** 3.83*** 23.15*** ?10.18*** 1.94
4.5 0.0415 ?0.2448 ?0.0021 GDPGR 4.1858 1.6818 ?0.7217 0.98
1.14 ?2.01** ?0.28 3.96*** 22.37*** ?9.76*** 1.96
4.6 0.0438 ?0.2529 0.0003 DEFICIT 4.0930 1.6977 ?0.7356 0.98
1.22 ?2.10** 1.20 3.80*** 23.10*** ?10.17*** 1.94
4.7 0.0459 ?0.2601 0.1199 TB3 3.9031 1.6185 ?0.6621 0.98
1.24 ?2.12** 1.36 3.64*** 19.77*** ?8.23*** 2.04
4.8 ?0.0116 ?0.1111 0.9372 TB6 1.0174 1.0538 ?0.2990 0.99
?0.38 ?1.93** 20.80*** 2.22** 10.17*** ?2.98** 1.93
4.9 0.0330 ?0.2151 0.0773 T10YR 3.691 1.6801 ?0.7220 0.98
0.89 ?1.71* 1.04 3.24*** 21.91*** ?9.55*** 1.99
4.10 0.0420 ?0.2442 ?0.0340 BERN 4.1965 1.6816 ?0.7220 0.98
1.15 ?2.01** ?0.15 3.98*** 22.44*** ?9.80*** 1.96
Notes: *Signifcant at the 10% level; **signifcant at the 5% level; ***signifcant at the 1% level
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The frst model for each rate (4.1 and 5.1, respectively) tests the hypothesis that a policy
rate is explained by only the rate of unemployment (U) and the rate of infation (INF).
The coeffcient of unemployment is negative, indicating falling rates when
unemployment rises, and statistically signifcant to explain each rate. Infation has a
positive coeffcient to explain each rate; however, in the Fed funds rate model, the
t-statistic for the coeffcient of INF is only 1.15, indicating little impact of infation on the
market Fed funds rate.
Alternative models
The explanatory power of additional variables is examined for nine additional models
for each policy rate. The statistically strongest and most interesting case includes a
forward perspective of potential recessions – including YLD3 ?T10YR – TB3 (models
4.2 and 5.2) and YLD6 ?T10YR – TB6 (models 4.3 and 5.3). As constructed here, YLD3
and YLD6 allowfor an inverted yield curve (YLD3 ?0 and YLD6 ?0), which is claimed
to project a future recession approximately one year in advance (see Estrella and
Mishkin, 1996; Powell, 2006; and Haubrich, 2006). An alternative to the models with
YLD3 and YLD6 is to introduce a binary variable to represent the 1990, 2001 and
2007-2009 US recessions (REC), as defned by the National Bureau of Economic
Research (2014). The models with YLD6 are statistically superior, on the basis of the
t-statistics, to the models with the binary recession variable (REC). To test whether the
periods for the Greenspan and Bernanke chairmanships were different, the binary
variable BERN is constructed to equal 1.0 for the later period. There appears to be no
difference in the periods.
Table V.
DR policy rate regression
models
Model INF U Variable Intercept AR(1) AR(2)
Adjusted R
2
DW
5.1 0.1019 ?0.4055 5.2720 1.4608 ?0.5231 0.97
2.06** ?2.70** 4.67*** 15.65*** ?5.70*** 2.27
5.2 0.0785 ?0.3455 0.1812 YLD3 4.7929 1.5749 ?0.6395 0.97
1.59 ?2.20** 1.80* 4.10*** 17.88*** ?7.40*** 2.25
5.3 0.1093 ?0.3712 ?0.5645 YLD6 5.9371 1.271 ?0.3258 0.98
2.41*** ?2.91*** ?5.63*** 5.58*** 12.05*** ?3.08*** 2.14
5.4 0.1065 ?0.4018 ?0.8000 REC 5.2367 1.4560 ?0.5173 0.97
2.12** ?2.66*** 0.59 4.59*** 15.45*** ?5.57*** 2.27
5.5 0.1020 ?0.3996 ?0.0115 GDPGR 5.2663 1.4699 ?0.5312 0.97
2.07** ?2.64*** ?1.09 4.63*** 15.69*** ?5.77*** 2.26
5.6 0.1002 ?0.3926 ?0.0002 DEFICIT 5.3083 1.4520 ?0.5172 0.97
2.01** ?2.56*** ?0.59 4.77*** 15.24*** ?5.54*** 2.26
5.7 0.1164 ?0.3629 0.5459 TB3 3.6629 0.9114 ?0.0897 0.97
2.13** ?3.16*** 6.16*** 3.99*** 8.48*** ?0.82 2.04
5.8 0.0516 ?0.1430 0.7903 TB6 1.6886 1.0322 ?0.2044 0.98
1.27 ?1.55 10.95*** 2.31** 9.78*** ?1.96** 2.05
5.9 0.0937 ?0.3875 0.0864 T10YR 4.8187 1.4518 ?0.5198 0.97
1.84* ?2.51*** 0.86 3.78*** 15.30*** ?5.55*** 2.26
5.10 0.1026 ?0.4049 ?0.0390 BERN 5.2890 1.4614 ?0.5245 0.97
2.05** ?2.68*** ?0.12 4.67*** 15.59*** ?5.69*** 2.27
Notes: *Signifcant at the 10% level; **signifcant at the 5% level; ***signifcant at the 1% level
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The models that include YLD6 have superior statistical results to the other models to
explain the Fed funds rate and the discount rate. For models 4.3 and 5.3, the coeffcient
of YLD6 is highly statistically signifcant. Also, for models 4.3 and 5.3 the infation
coeffcient has the highest t-statistic among any of the ten models for each of the two
rates. It is useful to include the difference between long-term and short-term rates to
explain the two policy rates.
The alternative models in Tables IV and V include real GDP growth (GDPGR), the
fscal defcit (DEFICIT), separate short-term and long-term Treasury securities’ rates
(TB3, TB6 and T10YR, respectively), and binary recession and Fed chair variables.
None of these models has statistical characteristics that are as strong as the primary
models (4.1 and 5.1) and the models that include the yield curve with TB6 (4.3 and 5.3).
Including the fscal defcit as a ratio to GDP provides an inferior model. The only
separate Treasury rate variable whose coeffcient is statistically signifcant is the
six-month Treasury bill rate, and in those regression models, the coeffcient of infation
is not different from zero at a meaningful probability level. The economic content of
these other factors, including whether there was a recession or who served as Fed Chair,
appears to be captured within U, INF and YLD6.
It appears that the FMOCis adjusting the discount rate and infuencing the Fed funds
rate in response to unemployment rates, infation rates and the prospect for a future
recession over the 1990-2013 period. Higher infation either leads to or is consistent with
increases in the discount rate, but the Fed funds rate is considerably less affected by
changes in infation. It is not surprising that the impact is stronger on the administered
discount rates. Evidently, the market rates have not reacted signifcantly to infation in
recent decades. This may occur because of the somewhat narrow range of levels of
infation over the 24-year period, 1990-2013. From Table III, the standard deviation of
INFis less than half of its mean. Declines in both policy rates occur when unemployment
increases and yield curves tilt, suggesting a future recession.
6. Conclusions
The predominant variable that explains both the Fed funds market rate and the
administered discount rate is the unemployment rate. There is a statistically signifcant,
inverse relationship between unemployment and each of these policy rates. The
representation of the yield curve has a signifcant negative coeffcient, suggesting that
an expected recession encourages lower policy discount and Fed funds rates. The
impact of changes in the infation rate has a smaller impact on the two policy rates, and
a questionable effect on the Fed funds rate; the impact of infation on setting the discount
rate is signifcant, but not as strong as the impact of unemployment. The coeffcients of
real GDP growth, the fscal defcit and the ten-year Treasury securities’ rate are not
statistically signifcant in determining either policy rate.
References
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Bernanke, B.S. and Binder, A. (1992), “The federal funds rate and the channels of monetary
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339
Federal Reserve
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Appendix
Corresponding author
David Walker can be contacted at: [email protected]
To purchase reprints of this article please e-mail: [email protected]
Or visit our web site for further details: www.emeraldinsight.com/reprints
Table AI.
Variable defnitions
Symbol Variable name
DR Discount rate
FF Fed funds rate
U Unemployment
INF Infation
GDPGR GDP growth rate
TB3 three-month treasury bill rate
TB6 six-month treasury bill rate
T10YR ten-year treasury security rate
YLD3 T10YR–TB3
YLD6 T10YR–TB6
NETEX Net exports
DEFICIT Fiscal defcit
REC Recession years: 1990Q3-1991Q1, 2001Q2-2001Q4, 2008Q1-2009Q2
BERN Bernanke Chairmanship 2006 Q1- 2013Q4
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