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This paper investigates how the implementation of monetary policy affects 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 refer to the role of the federal funds rate target and the reserve requirement system. We show that the improved communication and transparency regarding the federal funds rate target has significantly increased the Fed’s influence on the federal funds rate since 1994. By contrast, the declining role of required reserves in the US has contributed to higher federal funds rate volatility. Our results suggest that the introduction of remunerated required reserves will further enhance the controllability of the federal funds rate.

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.1 The current paper examines how major developments in the monetary framework of the Fed have influenced the dynamics and the volatility of the federal funds rate. For the US the most obvious changes in monetary policy implementation refer to the increasing role of the federal funds rate target. Before February 1994, the Fed’s interest target rate was more or less implicit and had to be inferred by the public from the Fed’s open market operations; see Thornton (2006). Since then, changes in the federal funds target rate have been announced and explained immediately after the Fed’s interest rate decision. The introduction of a balance of risk statement in 2000 might have further improved the communication and transparency of monetary policy, see Ehrmann and Fratzscher (2007). Furthermore, the role of required reserves has changed over time. During the 1990s sweep account programs could have significantly undermined the reserve base in the US, and thus the ability of required reserves to act as an interest rate smoothing liquidity buffer, see e.g. Woodford (2000). With a view to the recently introduced practice of remunerated reserves, our second focus is, therefore, on the role of required reserves for the volatility of the federal funds rate. Our paper essentially relates to three groups of papers. First, it adds to the growing literature on the volatility and the dynamics of overnight interest rates. Following the seminal paper by Hamilton (1996), recent examples include Bartolini and Prati (2006) and Pérez Quirós and Rodríguez Mendizábal (2006). Both contributions show that the central bank’s operational framework influences the behavior of overnight rates. Second, it is related to the recent literature on central bank communication, see Blinder et al. (2008). In particular, Swanson, 2006 and Lange et al., 2003 strongly suggest that a higher transparency has improved the predictability of the federal funds rate. Third, the literature has become increasingly interested in the role of required reserves in the money market. While the findings by Carpenter and Demiralp (2006) suggest that, in general, high levels of reserve balances mitigate intramaintenance period effects of liquidity supply shocks on the federal funds rate, Demiralp and Farley (2005) argue that the Fed and the banking system has adapted well to the particular decline in reserves of the mid-1990s. The aim of the current paper is to combine these different aspects of the former literature and to investigate them simultaneously in one model. In line with the empirical literature, we adopt the EGARCH-framework to model the mean and the time-varying volatility of the daily federal funds rate. In order to capture probably important long-run equilibrium relations governing the federal funds rate dynamics, we specify the mean equation of the EGARCH model as an error-correction equation where the federal funds rate adjusts to two interest rate spreads. In accordance with the expectations theory of the term structure, the federal funds rate (i ) may respond to the term spread , defined as the spread between the three month Treasury bill rate and the federal funds rate (i3-ii3-i). Following models of the European overnight rate suggested by Benito et al., 2007 and Nautz and Offermanns, 2007, we additionally account for the policy spread (i-i∗i-i∗) as a second error-correction term governing federal funds rate dynamics. We use this framework to test whether the adjustment to deviations from its target and thus the controllability of the federal funds rate depends on the importance and transparency of the federal funds rate target. Changes in monetary policy implementation may also affect the volatility of the federal funds rate. In particular, evidence provided by Hilton (2005) suggests that high reserve requirements stabilize the federal funds rate. Demiralp and Farley (2005), however, argue that the relationship between required reserves and interest rate volatility need not be negative if the Fed reacts to lower required reserves by expanding the liquidity supply management. In order to test whether required reserves contribute to lower interest rate volatility, we include a normalized measure of required reserves in the volatility equation of the federal funds rate. Our results clearly indicate that improved communication and transparency of monetary policy decisions significantly enforce the adjustment of the federal funds rate to its target. Therefore, a well-communicated implementation of monetary policy enhances the Fed’s control over the federal funds rate. In the same vein, results from the volatility equation show that the introduction of the balance of risks assessment in January 2000 has further contributed to stabilizing the federal funds rate. Controlling for the improved communication by the Fed reveals that the declining trend in required reserves has increased the interest rate volatility in the US. The remainder of the paper is structured as follows: Section 2 introduces the interest rate data and reviews the increasing role of the federal funds rate target in US monetary policy implementation. Section 3 describes the development of reserve requirements and their possible impact on the volatility of the federal funds rate. Section 4 presents the empirical model designed to test the implications derived in Sections 2 and 3 regarding the effects of monetary policy implementation on the dynamics and the volatility of the federal funds rate. Section 5 summarizes our main results and provides some concluding remarks.

This paper investigated the impact of the Fed’s implementation of monetary policy on 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 focused (1) on the role of different regimes of interest rate targeting and (2) on the effect of reserve requirements on the behavior of the federal funds rate. Contributing to the recent literature on the dynamics and volatility of overnight rates, we found 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 strengthened the link between the federal funds rate and its policy target. The introduction of the balance of risks assessment into the FOMC-statements in January 2000 improved the communication of the Federal Reserve 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. Partly reconciling the mixed evidence of earlier contributions, we showed that the volatility of the federal funds rate decreases with the level of required reserves provided that the changing communication of the Fed is taken into account. In response to the recent financial turmoil, the Fed has decided to pay interests on reserves in October 2008. Since this measure decreases the opportunity costs of holding reserves, it is supposed to increase banks’ reserve holdings. According to our empirical results, the remuneration of reserves will help to decrease the volatility of the federal funds rate in a significant way.