Dr. Econ: I know that short-term interest rates, including
the prime rate and LIBOR, are all highly correlated with
the federal funds rate. Additionally, it appears that federal
funds borrowing is very limited in scope compared to a bank's
total capital flows. Given the relatively small size of
the federal funds market, why are all short-term rates tied
to the federal funds rate?
Thank you for a very interesting question!
As many people know, the prime interest rate, or prime
is a commonly used reference rate for floating interest rate
small business and consumer loans offered by banks. Individual
loan rates often are set at some discount or premium to the
prime rate, such as prime plus 1 percent. LIBOR, which stands
Interbank Offered Rate, is the interest rate at which major international
banks are willing to offer Eurodollar deposits to one another.
Finally, the federal funds rate is the rate U.S. banks charge
on overnight loans to banks that need to borrow to meet their
reserve requirements. The target federal funds rate, set
by the Federal
Open Market Committee,
is the most commonly used tool of U.S.
Indeed, there is a very high correlation
between the funds rate and other short-term interest rates.
For example, as shown in Figure 1, the correlation between
the overnight federal funds rate and a six-month Treasury
bill rate is 0.99 (the highest correlation coefficient possible
There also is a strong correlation between
the effective federal funds rate and longer-term interest
rates. As shown
in Figure 2, the correlation between the federal funds
rate and the ten-year Treasury bill rate is 0.73.
As for the size of the interbank loan market, it is rather
large, with daily loans between banks—fed funds would
account for the largest share these—averaging over
$300 billion dollars a day in 2006. In this market, the
bulk of the $300 billion dollars in loans are either repriced daily or traded every day.
The following excerpts from Fed resources might help you
to understand the link between the federal funds rate and
other interest rates in the economy:
1. Website of the Federal Reserve Bank of NY: “About
the Fed” section:
The fed funds rate can be viewed as the marginal cost of
borrowing for banks, which banks must consider when setting
the interest rate they charge borrowers:
Movements in the federal funds rate have important implications
for the loan and investment policies of all financial institutions,
especially for commercial bank decisions concerning loans
to businesses, individuals, and foreign institutions. Financial
managers compare the federal funds rate with yields on other
investments before choosing the combinations of maturities
of financial assets in which they will invest or the term
over which they will borrow. Interest rates paid on other
short-term financial securities—commercial paper and
Treasury bills, for example—often move up or down roughly
in parallel with the funds rate. Yields on long-term assets—corporate
bonds and Treasury notes, for example—are determined
in part by expectations for the federal funds rate in the
2. October 11, 2002 Economic Letter, "Setting the Interest
This article explains that short-term interest rates may
move together because they are close substitutes:
Why do movements in the federal funds rate influence
the [repo or] RP rate and other short-term market rates?
a commercial bank wants to raise overnight funds on short
notice. It might borrow reserves in the federal funds market,
or it might sell securities "under repo." In the
former case, the bank borrows at the federal funds rate;
in the latter case, it borrows at the RP rate. Because there
are only minor differences in the quality of the two assets,
their rates remain very closely tied together due to the
elimination of arbitrage opportunities that would otherwise
exist for banks who participate in both markets. Similarly,
other short-term money market interest rates respond in kind
in order to maintain a portfolio balance under which all
assets yield the same expected return after adjusting for
risk, maturity, and liquidity differences. Hence, when the
Fed adjusts its target for the federal funds rate, all other
short-term interest rates tend to move with it. Indeed, some
short-term interest rates may change in anticipation of the
change in the target.
3. A 2004
speech on monetary policy by then-Governor and
now Federal Reserve Board Chairman Ben Bernanke.
The following excerpt explains how expectations link short-term
Although the relation between the FOMC's setting of the
federal funds rate and the more economically relevant long-term
yields is hardly direct or mechanical, a critical connection
does exist. The connection operates less through the current
value of the funds rate, however, than through the interest-rate
actions that the FOMC is expected to take in the future.
Specifically, financial theorists and market practitioners
concur that, with risk and term premiums held constant, long-term
yields move closely with the expectations that financial-market
participants hold about the future evolution of the funds
rate and other related short-term rates. For example, all
else being equal, if short-term rates are expected to be
high on average over the relevant period, then longer-term
yields will tend to be high as well. Were that not the case,
investors would profit by holding a sequence of short-term
securities and declining to hold long-term bonds, an outcome
inconsistent with the requirement that, in equilibrium, all
securities must be willingly held. Likewise, if future short-term
rates are expected to be low on average, then long-term bond
yields will tend to be low as well.
Booth, James. (1994) “The Persistence of the Prime
Rate.” Federal Reserve Bank of San Francisco, FRBSF
Weekly Letter, Number 94-20; May 20, 1994.
Federal Funds. (2007) Fedpoints. Federal Reserve Bank of
Furlong, Fred. (1991) "Is the Prime Rate Too High?" Federal
Reserve Bank of San Francisco, FRBSF Weekly Letter, Number
91-25; July 5, 1991.
of the Money Market. (2006) Federal Reserve
Bank of Richmond.
Laderman, Elizabeth. (1990) “The Changing Role of
the Prime Rate.” Federal Reserve Bank of San Francisco,
FRBSF Weekly Letter, July 13, 1990.
Marquis, Milton. (2002) “Setting the Interest Rate.” Federal
Reserve Bank of San Francisco, FRBSF Economic Letter, Number
2002-30; October 11, 2002.
Mishkin, Frederic S. and Stanley G. Eakins. (2000) Financial
Markets and Institutions. Addison-Wesley: Reading, Massachusetts.
Interest Rates. Board of Governors of the Federal Reserve
Reserve Statistical Release H.15.
Survey of Terms of Business Lending. Board of Governors
of the Federal Reserve System, Federal
Reserve Statistical Release E.2.