The Fed’s Effective Proxy Battle

February 16, 2023 | James Torgerson, Senior Research Analyst

The Federal Reserve’s sharp tightening of interest rates over the last year has made financial market conditions significantly more restrictive. However, financial conditions may be even tighter than generally recognized based on the fed funds rate alone. The San Francisco Federal Reserve Proxy Rate is a measure that uses public and private borrowing rates and spreads to better reflect broader monetary policy. The proxy rate represents the fed funds rate that would typically be associated with current market conditions, assuming financial markets are driven solely by this rate.

As of the end of January, the proxy rate was 6.1%, notably above the effective fed funds rate of 4.3%. The higher proxy rate indicates that broader monetary policy is tighter than what is implied by the fed funds rate alone. The proxy rate also started increasing in November 2021, while the Fed did not begin raising rates until March 2022, showing that broader financial market conditions have actually been tightening for more than a year. With markets extremely sensitive to Federal Reserve policy decisions, but the long-term health of the economy dependent on cooling price pressures, a higher proxy rate may be a hidden positive for markets.

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