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The Fed’s Effective Proxy Battle

February 16, 2023 | James Torgerson, Research Analyst

Two-line chart comparing San Francisco Fed Funds Proxy Rate and Effective Fed Funds rate. Chart subtitle: The San Francisco Fed Funds Proxy Rate is materially higher than the effective fed funds rate, indicating broader financial market conditions are tighter than what is reflected by the fed funds rate alone. Chart visual description: Y-axis is labeled “Effective & Proxy Fed Funds Rate” and spans -2% to +8%. X-axis is labeled with Jan-“year” in one-year increments, from Jan-00 to Jan-23. Periods of hiking are shaded in grey. Periods of recession are shaded in light teal. The SF Proxy rate line is in dark blue and effective fed funds rate is in orange. Chart data description: At beginning of charted data, both lines peaked for period shown, with SF at 7.63% in May 2000 and effective fed funds at 6.54% in July 2000. From there, both lines fell in the wake of the Dot-Com Crash, then began to steadily climb in 2004 during a hiking period, peaking around 5% in 2H2006. Both fell sharply during the mid-2007’s Global Financial Crisis, held mostly flat at 0 (or below 0 for the SF rate), up to 2016, then steadily climbed toward 3% in 2019. From a few slight drops, both again fell in 2020’s COVID downturn, up to 2022 when hikes began again. As of January 2023, the SF Proxy Rate is at 6.1% while the effective fed funds rate is 4.3%. Chart source: Bloomberg, Federal Reserve Bank of San Francisco, NBER as of January 31, 2023. End chart description. See disclosures at end of document.

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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