The dynamic relationship between the federal funds rate and the Eurodollar rates under interest-rate targeting

Purpose – Previous literature for the relations between the market interest rates and the targeted or target rate of the Federal Reserve paid little attention to Eurodollar market rates. The present paper attempts to fill this void. Design/methodology/approach – The study investigates the dynamic relationship between the federal funds rate and three short-term Eurodollar deposits rates. Cointegration analysis is utilized to examine the long-run relationships between the short-run dynamics of the market and targeted rates through a vector error-correction mechanism. Findings – The study shows strong evidence that, while the Eurodollar rates and the federal funds rate move together over time regardless of procedural differences in targeting, how they co-move, especially how they adjust toward long-run equilibrium, appears to be related to the targeting procedural changes. Research limitations/implications – Further research should be conducted for the theoretical analysis of strategic interactions between the monetary authority and market participants in the domestic and external financial markets. Practical implications – The result suggests that the Fed may affect the market interest rates through a policy of changing the federal funds rate target by a “fixed” amount for the foreseeable future. Such a policy has improved the market's ability to predict the size and timing of the changes in the target rate. Originality/value – The results of the paper give some new insights into the interactions between monetary policy operations and market interest rates, which is of interest to researchers, monetary authorities, and financial market participants.