What's Unique About the Federal Funds Rate? Evidence from a Spectral Perspective*
| Author | Yi Wen,Lucio Sarno,Daniel L. Thornton |
| DOI | http://doi.org/10.1111/j.1468-0084.2006.00444.x |
| Published date | 01 April 2007 |
| Date | 01 April 2007 |
What’s Unique About the Federal Funds Rate?
Evidence from a Spectral Perspective*
Lucio Sarno,Daniel L. Thorntonàand Yi Wenà
Finance Group, Warwick Business School, University of Warwick,
Coventry, UK and Research Affiliate, Centre for Economic Policy Research, London, UK
(e-mail: lucio.sarno@warwick.ac.uk)
àResearch Division, Federal Reserve Bank of St Louis, St Louis, MO, USA
(e-mail: thornton@stls.frb.org; yi.wen@stls.frb.org)
Abstract
This paper compares the behaviour of the effective federal funds rate to 10 US
interest rates with maturities ranging from overnight to 10 years. Using spectral
estimation methods, we identified idiosyncratic shocks to the funds rate and
provided evidence on their impact on other rates at various frequencies. Our results
suggest that, while all of the interest rates examined have common shocks at
low frequencies, the federal funds rate contains some unique information at
high frequency, although this information appears to be relevant only at the short
end of the term structure. In turn, these results are open to various alternative
interpretations.
I. Introduction
A vast body of empirical literature has studied the response of economic variables
to exogenous monetary policy shocks. A large proportion of this literature identifies
monetary policy shocks using the effective federal funds rate (see, inter alia,
Christiano, Eicherbaum and Evans, 1992, 1996a,b, 1999; Clarida, Gali and Gertler,
*We are grateful to Christopher Bowdler (editor), three anonymous referees, Ken West and Arnold Zellner
for comments on a previous version. This paper was begun while Lucio Sarno was visiting the Federal
Reserve Bank of St Louis and Yi Wen was on the staff of Cornell University. The views expressed here are
the authors’ alone and do not necessarily reflect the views of the Board of Governors of the Federal Reserve
System or the Federal Reserve Bank of St Louis.
JEL Classification numbers: E43, G10.
OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 69, 2 (2007) 0305-9049
doi: 10.1111/j.1468-0084.2006.00444.x
293
Blackwell Publishing Ltd and the Department of Economics, University of Oxford, 2007. Published by Blackwell Publishing Ltd,
9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.
1998, 2000; Clarida, 2001; Thornton, 2001; Chadha, Sarno and Valente, 2004). The
importance of the federal funds rate in the US money market and the US economy
as a whole is unquestionable. Open market operations, which the Federal Reserve
(Fed) regularly conducts to implement monetary policy, have a direct effect on
reserves and, thereby, the federal funds rate. Moreover, the Fed has often relied
explicitly on the overnight federal funds rate to implement policy. It did so from
the mid-1970s until October 1979, and switched from a narrow money targeting
procedure to an explicit federal funds rate operating procedure in the early 1980s.
1
Indeed, Goodfriend (1991) argues that the Fed has targeted the federal funds rate
either implicitly or explicitly throughout its history.
2
Given the Fed’s reliance on
open market operations to implement policy and the role of the effective federal
funds rate in the Fed’s operating procedure, it is not surprising that shocks to the
federal funds rate are routinely used as monetary policy shocks in much research in
empirical macroeconomics and monetary economics.
However, identifying monetary policy shocks using the funds rate or, more
generally, understanding the nature of the information embedded in movements
in the funds rate, is cumbersome. For example, Hamilton’s (1997) warns that
exogenous shocks to monetary policy can only be identified reliably using daily data
and provides evidence suggesting that low-frequency data are unlikely to measure
accurately monetary policy shocks and their impact on the term structure of interest
rates. Our paper contributes to this broad literature by investigating whether there is
unique information in the funds rate, and the nature of this information. If the federal
funds rate does not contain unique information, there is no particular reason to use
the funds rate to identify ‘monetary policy shocks’, as is done in much of the
empirical literature. If the funds rate contains unique information, extracting the
unique information in the funds rate and examining the relation of this information
to other US interest rates could improve our understanding of the transmission
of monetary policy from the federal funds rate to other interest rates and, perhaps
indirectly, to the rest of the economy.
Specifically, we focus on the effective federal funds rate and 10 other US interest
rates with maturities ranging from overnight to 10 years, examining empirically both
daily and monthly time series since 1974. Our empirical strategy is based on an
econometric procedure recently developed by Wen (2001, 2002). This procedure is
based on the frequency domain representation of a vector autoregression (VAR).
Unlike the conventional structural VAR approach carried out in the time domain,
where monetary policy shocks are commonly identified by imposing a specific
recursive ordering or a Wold causal chain on the variables in the VAR (typically by
1
See Thornton (2006) for evidence that the Fed began targeting the funds rate in the early 1980s. For a
discussion of alternative operating procedures used by the Fed to implement monetary policy, see, for
example, Meulendyke (1998). For excellent reviews of the issues related to empirically identifying monetary
policy shocks and gauging their impact on other economic variables, see, for example, Christiano et al.
(1999) and Clarida (2001).
2
This argument is also implicit in Taylor’s (1993) historical analysis of the US monetary policy.
294 Bulletin
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