03-30-2026
In my February post on monetary policy and financial conditions, I argued that monetary policy affects economic growth and inflation through its impact on financial market conditions — in particular, by affecting longer-term interest rates such as the 10-year Treasury and the 30-year mortgage rates. This raises an interesting question. How does the Fed’s policy rate — the Federal Funds Rate (FFR), which is an overnight interest rate associated with borrowing and lending of reserves between banks — affect these long-term interest rates?
Businesses and households never participate in the Federal Funds market. Why would we expect this very short-term interest rate in an obscure interbank market to have any influence over a $30 trillion economy? On its face, it would seem that Congress gave the Fed a dual mandate, but an impossibly weak instrument with which to meet this mandate.
Like Aesop’s fable “The Lion and the Mouse,” sometimes the mouse (monetary policy) can save the lion (the economy). The key is to understand how arbitrage is the ubiquitous force that shapes financial markets. In the case of monetary policy and the FFR, the arbitrage is between short- and long-term interest rates.
Consider a “risk-neutral” individual who does not require any premium to hold risk. Assume that this individual would like to save for a funding need in four weeks. One alternative is to purchase a four-week Treasury Bill. This will provide the individual with a specified return at the end of four weeks.
Suppose that the individual can also put his funds in an overnight investment that pays an interest rate similar to the FFR. The individual could then roll over the balance daily for four weeks. The return that the individual expects to receive from this alternative investment approach depends on the current overnight interest rate and the expectation for this overnight interest rate over the four-week period. Arbitrage indicates that our individual needs to be indifferent between holding the four-week Treasury Bill or rolling an overnight investment for the 4-week period.
If there are many such individuals, then the four-week Treasury rate through arbitrage will depend on the current overnight interest rate and the market expectation for this rate over the four-week period. That is, changes in the overnight interest rate and its expected future values will move the four-week Treasury Bill rate (and vice versa).
This similar arbitrage exists for even longer-term securities such as the 10-year Treasury note. This is the “expectations” channel for monetary policy. What is important to note is that the 10-year Treasury rate depends much more on expectations for future FFRs than it does on the current FFR. This is why central banks have worked over time to improve their transparency with markets. The better markets can anticipate how the Fed will adjust its monetary policy in future meetings, the more accurate the market’s expectations will be for the path of the FFR. This shortens the lag for how monetary policy affects the economy and inflation. Long-term interest rates will adjust to “news” about monetary policy even before these future changes to monetary policy are decided.
An important feature of the expectations channel of monetary policy is that the Fed is working with financial markets rather than against financial markets. That is, the Fed is not dictating any long-term interest rate. The financial market is still adjusting the full range of interest rates to incorporate all available relevant public information.
A second feature of the expectations channel of monetary policy is that the Fed does not target any specific sector of the economy. Rather, changes in monetary policy are transmitted throughout the financial system through arbitrage. This helps to preserve the independence of the Fed as its policy actions are directed at the economy overall and not at specific sectors. That is, the Fed is not playing favorites.
Finally, a third feature of the expectations channel of monetary policy was that prior to the Financial Crisis the Fed was able to successfully target its desired FFR using a balance sheet of short-term Treasuries that was less than a trillion dollars — that is, less than 8 percent of the size of the economy.
Prior to the Financial Crisis, the Fed had essentially no credit or interest rate risk associated with its balance sheet. Consequently, when the Fed was focusing just on the expectations channel to implement monetary policy, it never lost money and every year transferred its profits to the Treasury.
The magic of monetary policy is how an obscure overnight interest rate in the federal funds market can allow the Fed to achieve its dual mandate from Congress. Like the mouse in Aesop’s fable, prior to the Financial Crisis the Fed operated with a very small footprint on the economy. When the economy needed to be freed from the “net” of high inflation or unemployment, monetary policy could magically rise to the occasion. As the mouse told the lion after freeing it, “Now you see that even a mouse can help a lion."
Joseph Tracy is a Distinguished Fellow at Purdue University’s Daniels School of Business and a nonresident senior fellow at the American Enterprise Institute. Previously he was executive vice president and senior advisor to the president at the Federal Reserve Bank of Dallas. He regularly contributes insightful posts about financial markets to Daniels Insights.
