The Dynamic Relationship Between the Federal Funds Rate and the Treasury Bill Rate

ABSTRACT: This article examines empirically the dynamic relationship between two key US money market interest rates – the federal funds rate and the 3-month Treasury bill rate. Using daily data over the period 1974-1999, we show that a long-run no-arbitrage relationship exists between these two rates. This relationship is shown to be remarkably stable across monetary policy regimes of interest rate and monetary aggregate targeting. Employing vector equilibrium correction models which allow for both asymmetric and non-linear dynamics, we find that most of the adjustment towards the no-arbitrage long-run equilibrium occurs through the federal funds rates. The results appear to suggest that, contrary to conventional wisdom, it is the Treasury bill rate, rather that federal funds rate, that ‘anchors’ the short end of the term structure.

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