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As I understand it the Fed has 3 tools for moving interest rates to combat inflation/unemployment: the discount rate, Fed Funds rate and open market operations.

I'm trying to understand how the yield curve is affected:

The Fed Fund rate is the overnight rate at which reserve balances, held by banks at the fed can be lent to each other. The shortest maturity that the treasury yield curve has is 1 month (no overnight). Are expectations regarding overnight fed funds rates reflected in the 1 month yields? I would suppose so, because if the government raises fed funds, their intentions are to influence and increase interest rates in general. Thoughts?

The discount rate is the interest the Fed charges other banks to borrow money. Does the 'discount rate' relate to the commercial paper listed here?. Am I correct in thinking that the discount rate refers to short term borrowing < 1year and that changes in the yield curve at maturities greater than 1 year may not be directly correlated to changes in fed funds or discount rates? (because these are not tools for influencing long term rates)

Finally I understand that changes in the curve at longer maturities may reflect the governments 'open market operations' and their buying and selling of US securities.

Any help solidifying this understanding would be much appreciated.

PART 2 TO THIS QUESTION HERE

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You've asked a lot of questions, so I will have to keep my answers rather brief.

As I understand it the Fed has 3 tools for moving interest rates to combat inflation/unemployment: the discount rate, Fed Funds rate and open market operations.

This is incorrect in a few ways:

  1. The discount rate is a tool, but it's not a tool that is used to conduct monetary policy in normal times. It is, instead, a "penalty rate" in the sense used by Walter Bagehot.
  2. The Fed Funds rate is not a tool, it is a target. The Fed Funds rate is calculated from market transactions, and the Federal Open Market Committee will often instruct the Federal Reserve Bank of New York to engage in open market operations to move the Fed Funds rate toward a particular level.
  3. These are not the only tools at the Fed's disposal. It also has, for example, the reverse repurchase program, which enables it to set a floor under short-term secured borrowing rates.

Are expectations regarding overnight fed funds rates reflected in the 1 month yields?

Yes, they are related, though the yield on a 1-month Treasury bill will in practice differ from the compounded Fed Funds rate for a number of reasons. One notable reason is that the Fed Funds rate, being a market rate, does vary, while the yield on a 1-month Treasury is effectively fixed at the time of purchase. The relationship between the expected values of a fixed rate and a floating rate is expressed through Overnight Indexed Swap values, and 1-month OIS on the Fed Funds rate is the best direct indication of the expected value of compounded overnight borrowing in the Fed Funds market.

...stuff about the discount rate...

No, as I said above. On an average day, bank borrowing from the discount window should be zero. Commercial paper represents medium-term borrowing by private companies.

Finally I understand that changes in the curve at longer maturities may reflect the governments 'open market operations' and their buying and selling of US securities.

Yes, but that's also true of the short end of the curve. In fact, sometimes the Fed has sought to change the relationship of the short and long ends of the curve, as in "Operation Twist".

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  • $\begingroup$ Much appreciated @dismalscience: just to confirm; the discount window should be reserved for crisis because it lends in line with Bagehot's Dictum: To avert panic, central banks should lend early and freely (ie without limit), to solvent firms, against good collateral, and at 'high rates.' These high rates could also be called penalty rates. $\endgroup$ – DVCITIS Jan 28 '16 at 17:25
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    $\begingroup$ @Pete Yes. While the discount window may sometimes be used by institutions facing idiosyncratic stress, rather than only in a broad crisis, it's discouraged, and is a flag to banking regulators to take a close look at the institution that is borrowing. $\endgroup$ – dismalscience Jan 28 '16 at 17:29
  • $\begingroup$ Cool, my understanding of monetary policy is slowly growing. I've developed this question a little further and posted an update at the below link if interested: $\endgroup$ – DVCITIS Jan 28 '16 at 18:21
  • $\begingroup$ quant.stackexchange.com/questions/22993/… $\endgroup$ – DVCITIS Jan 28 '16 at 18:21

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