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Economic SYNOPSES
short essays and reports on the economic issues of the day
2007 ■ Number 10

The Federal Funds and Long-Term Rates
Daniel L. Thornton
he Federal Open Market Committee (FOMC) increased
its target for the federal funds rate from 1.0 percent in
late June 2004 to 5.25 percent (as of February 2007) in
a series of 17 consecutive 25-basis-point adjustments. But this
rise in the funds rate is not reflected in long-term yields: The
10-year Treasury yield averaged 4.73 percent in June 2004 and
4.72 percent in February 2007. It is widely accepted that the
absence of a change in long-term yields alongside a large change
in the funds rate marks a break in the historical relationship
between these rates and has been referred to as a “conundrum.”
I argue that the break in this relationship between long-term
and short-term rates may have occurred in the early 1990s.
It is well known that over sufficiently long periods of time
long-term and short-term rates move together. The attached
chart shows this by plotting the effective federal funds rate,
the 10-year Treasury yield, and the ratio of the 10-year yield
to the federal funds rate from May 1982 to February 2007. The
ratio is close to 1.0 at the beginning and end of the period,
after both rates had declined by about 900 basis points. From
May 1982 to late 1990 the funds rate and the 10-year yield
moved relatively closely together, and the ratio deviated relatively little from 1.0 despite relatively large swings in rates. As
rates continued to fall in the early 1990s (the
funds rate declined more than the 10-year
16.00
yield), the ratio increased to a peak of nearly
2.32 in December 1992. Moreover, the devia14.00
tion of the ratio from 1.0 was very persistent,
with the ratio remaining above the previous
12.00
peak from the May 1991–January 1995 sample
period. The ratio began increasing dramati10.00
cally in early 2001, reaching a peak of 4.59 by
8.00
June 2004 before falling back to 1.0; during
this time, the FOMC was increasing its target
6.00
federal funds rate relative to an essentially
unchanged 10-year yield.
4.00
Larger and more persistent departures of
the ratio from 1.0 since the early 1990s, despite
2.00
the less-variable long-term yield, suggest that
0.00
the recent conundrum may be a dramatic
May
May
82
84
example of a fundamental change in the rela-

T

tionship between the federal funds rate and the 10-year yield
that occurred in the early 1990s.
This interpretation is supported by regressing monthly
changes in the 10-year yield on monthly changes in the funds
rate. When the equation is estimated using monthly data over
the May 1982–December 1990 period, the estimated slope
coefficient is 0.41 (indicating that, on average, a 100-basispoint change in the funds rate would be associated with a 41basis-point change in the 10-year yield) and is highly statistically significant, with a t-statistic of 5.46. Moreover, the adjusted
–
R-squared (R 2) is 22 percent, indicating that 22 percent of the
monthly variation in the 10-year yield is accounted for by the
funds rate. However, when estimated over the January 1991–
June 2004 period, the estimated slope coefficient declines to
0.14 and is not statistically significant. Indeed, the estimated
–
R2 indicates that the funds rate accounts for less than 1 percent
of the monthly variation in the 10-year yield over this period.
The results are not appreciably different when the equation is
estimated over the July 2004–February 2007 period. Furthermore, the results are qualitatively the same if quarterly data
are used. The reason for this marked change in the behavior
of these rates is a topic for further research. ■

5
Funds Rate

4.5

10-Year Yield
4

Ratio (right axis)

3.5
3
2.5
2
1.5
1
0.5
0
May
86

May
88

May
90

May
92

May
94

May
96

May
98

Views expressed do not necessarily reflect official positions of the Federal Reserve System.

research.stlouisfed.org

May
00

May
02

May
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