Monetary Policy Implementation and the Federal Funds Rate

For many central banks, overnight money markets are the key channel through which monetary policy is executed. Overnight rates, such as the US federal funds rate, are the operational targets of monetary policy that signal the policy-intended interest rate level. Since the 1980s, many central banks, including the Federal Reserve (Fed), have redesigned their monetary policy instruments to ensure that the overnight rate closely follows the central bank’s key policy rate and that its volatility remains well contained. This paper investigates how changes in the Fed’s implementation of monetary policy have influenced the dynamics and the volatility of the federal funds rate. Since the early 1980s, the most important changes in the Fed’s conduct of monetary policy have referred to the transparency and communication of the federal funds rate target and the working of the reserve requirement system. As a consequence, our empirical analysis focuses on the role of different regimes of interest rate targeting and on the effect of required reserves on the behavior of the federal funds rate. We find that the Fed’s steps towards a more transparent interest rate targeting have improved the Fed’s control of the federal funds rate. In particular, the immediate release of monetary policy decisions introduced in February 1994 significantly accelerated the adjustment of the federal funds rate to the policy target rate. The introduction of the balance of risks assessment into the monetary policy statements in January 2000 improved the communication of the Fed concerning the future interest rate path. In fact, we find that this recent step towards more transparency further contributed to stabilize the federal funds rate. By contrast, the declining trend in required reserves has increased interest rate volatility in the U.S. Paying interest on reserves as it is planned from 2011 onwards shall broaden the reserve base and consequently increase reserve requirements. As a consequence, our empirical findings suggest that the planned introduction of remunerated reserves will decrease the volatility of the federal funds rate in a significant way.

Nautz, Dieter and Sandra Schmidt (2008), Monetary Policy Implementation and the Federal Funds Rate, ZEW Discussion Paper No. 08-025, Mannheim.