Chapter 16 Structure of Central Banks and the Federal Reserve System

The Big Questions 1.What is the role of the central bank? 2.What are central bank objectives? 3.How are successful central bank’s organized? My presentation differs from Mishkin’s

Central Banks There are about 170 central banks in the world today. Nearly every country has one. Central Banking is largely a 20 th -century phenomenon. In 1900, only 18 countries had central banks. When the Soviet Union collapsed in 1990, the 12 of the 15 republics had central banks within a year

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Role of the Central Bank: The Government’s Bank  Manage the finances of the government.  Control the availability of money and credit. They create money. Monetary Policy – Expansionary/Tight

Role of the Central Bank: The Banker’s Bank Three important day-to-day functions of the central bank  Manage the payments system (settle inter-bank payments).  Provide loans during times of financial stress (the lender of last resort credits facilities).  Oversee commercial banks and the financial system to ensure confidence in their soundness (regulatory oversight).

The Primary Objectives of all Central Banks  Low, stable inflation  High, stable growth with high employment  stable financial markets  interest rate stability  exchange rate stability

Should Price Stability be the Primary Goal? In the short run, goal of price stability can conflict with the goal of high employment.  Conflicting goals implies trade-off By law, the goals of the Fed are price stability and high employment  Known as the “dual mandate” – price stability and high employment ECB has a hierarchical mandate, price stability first, then growth and employment

Why is Low and Stable Inflation Desirable? Usefulness of money as a store of value and medium of exchange reduced by inflation. High inflation is accompanied by unpredictable inflation makes bonds risky. In this environment: i = r + π e + risk premium. Long-term planning difficult Home Mortgage Retirement planning.

Stable Inflation: US. Inflation From 1970

How Low Should Low Be? No agreement. Zero inflation is probably too low. - risk of deflation (a drop in prices) which in turn results in increased defaults on loans and a threat to the health of banks. Should there be an inflation target in the US? Some countries have explicit inflation targets - generally at 2%.

Why is High & Stable Growth Desirable? Stable countries grow faster unstable growth creates risk risk increases interest rates higher interest rates mean lower investment lower investment means lower growth

Countries with stable growth grow faster

US GDP Growth Rate from 1960

Stable Financial Markets Financial collapse of the 1930s. Fed’s actions under Greenspan 1987, 1997, 2001 Fed’s actions under Bernanke  Yellen’s primary concern is growth Central banks want to minimize the risk of a disaster - keep the chance of maximum loss as small as possible. Value-at-Risk

Origins of the Federal Reserve System Strong resistance to establishment of a central bank in the US: Fear of centralized power Distrust of moneyed interests No lender of last resort  Nationwide bank panics on a regular basis  Panic of 1907 so severe that the public was convinced a central bank was needed Federal Reserve Act of 1913  Elaborate system of checks and balances  Decentralized

Structure of the Federal Reserve System Designed to diffuse power along the following dimensions: ─ Regions of the U.S. ─ Government and private sector interests ─ Needs of bankers, businesses, and the public The system as it exists now includes: ─ Twelve Federal Reserve Districts ─ Board of Governors of the Federal Reserve System ─ Federal Open Market Committee (FOMC) ─ Member Banks (around 2,800)

The Federal Reserve System - Structure Twelve Regional Banks

Twelve Regional Federal Reserve Banks Quasi-public institutions owned by the private commercial banks in the district that are members of the Fed system Member banks elect six directors for each district; three additional directors are appointed by the Board of Governors  Three Class A directors are professional bankers  Three Class B directors are prominent leaders from industry, labor, agriculture, or consumer sector  Three Class C directors appointed by the Board of Governors are not allowed to be officers, employees, or stockholders of banks

Functions of the Regional Federal Reserve Banks Clear checks Issue new currency and withdraw damaged currency from circulation Administer and make discount loans to banks in their districts Evaluate proposed mergers and applications for banks to expand their activities

Regional Federal Reserve Banks and Monetary Policy They “establish” the discount rate Decide which banks can obtain discount loans Five of the 12 bank presidents have a vote in the Federal Open Market Committee (FOMC)

Special Role of the FRB of New York The New York Fed houses the open market desk. All of the Feds open market operations are directed through this trading desk. The president of New York Fed is the only permanent member of the FOMC, serving as the vice-chairman of the committee.

Member Banks All national banks are required to be members of the Federal Reserve System Commercial banks chartered by states are not required but may choose to be members Depository Institutions Deregulation and Monetary Control Act of 1980 (affectionately referred to as MCA) subjected all banks to the same reserve requirements as member banks and gave all banks access to Federal Reserve facilities

Board of Governors of the Federal Reserve System Seven members headquartered in Washington, D.C. Appointed by the president and confirmed by the Senate 14-year non-renewable term Chairman is chosen from the governors and serves four-year term tthefed/default.htm

Duties of the Board of Governors Serve on the FOMC and vote on conduct of open market operations Set reserve requirements within a statutory range of 8 to 14 percent for transactions deposits and 0 to 9 percent for non- transactions deposits. Control the discount rate through “review and determination” process

Duties of the Board of Governors (cont’d) Set margin requirements Approve bank mergers and applications for new activities Supervise the activities of foreign banks operating in the U.S.

Federal Open Market Committee (FOMC) Meet eight times a year Consists of seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and the presidents of four other Federal Reserve banks Chairman of the Board of Governors is also chair of FOMC Issues directives to the trading desk at the Federal Reserve Bank of New York

Principles of Central Bank Design (How do you structure a Central Bank) Independent Decision-making by committee Transparency Accountability

Principles of Central Bank Design: Independence Politicians have an incentive to create short- term prosperity at the expense of inflation in the long-term. Central bank policy makers must think in terms of long-term inflation. To keep inflation low, monetary decisions must be made free of political pressure.

Is the Fed Independent ? Factors making Fed independent 1.Members of Board have long terms (14 years) 2.Fed is financially independent (this is most important). Income on bond portfolio, check clearing and loans to commercial banks. 3. Instrument independence and goal independence  Fed is free to choose instruments  Fed is free to set goals of monetary policy  FOMC policies can not be reversed Factors making Fed dependent 1. Congress can amend the Federal Reserve Act 2.President appoints Chairmen and Board members and can influence legislation Overall: Fed is quite independent

Financially Independent In 2013, Earned about $90 Billion on securities Expenses: interest on reserves of $5.2 Billion and other expenses of $7 Billion Turned $78 Billion over to Treasury earned $115B on securities and turned over $98B to Treasury.

Instrument and Goal Independence Instrument Independence: the ability of the central bank to set monetary policy instruments.  Increase/decrease in interest rates  Increase/decrease in money supply Goal Independence: the ability of the central bank to set the goals of monetary policy  Inflation  Growth and employment. The Fed has instrument and goal independence

Should The Fed be Independent? Case For: Independent Fed has longer-run objectives, politicians don't. Data shows independence produces better policy outcomes. Avoids political business cycle Less likely deficits will be inflationary Case Against: Fed may not be accountable Hinders coordination of monetary and fiscal policy

Principles of Central Bank Design: Decision-Making Framework Should policy be made by an individual or by a committee? Pooling the knowledge of a number of people yields better decisions than decision making by an individual.

Principles of Central Bank Design:Transparency Policymakers must clearly communicate their objectives, decisions, and methods to the public.

Principles of Central Bank Design: Accountability Policymakers must be held accountable to elected representatives and the public they serve. U.S. - Full Employment Act of 1946 ECB - price stability England and Canada and 21 other countries - explicit inflation targets

European Monetary Union began January 1, 1999 Euro began circulation January 1, of 29 countries in the European Union use the Euro European Central Bank(ECB) o/html/map.en.html

European Central Bank (ECB) Organizational Structure Six Member Executive Board similar to Fed Board or Governors (8 year term)  President and Vice-President 19 National Central Banks (Web Links)Web Links Similar to Fed District Banks. Governing Council similar to the FOMC.  Six Member Executive Board plus governors of 19 euro area banks

The European Central Bank Policy Framework: Treaty of Maastricht "The primary objective of the European System of Central Banks shall be to maintain price stability. Without prejudice to the objective of price stability, the ECB shall support the general economic policies in the [European] Community, including the objective of sustainable and noninflationary growth.” Price stability is defined as inflation close to 2 percent.

Governing Council Monthly meetings at ECB in Frankfurt, Germany 18 or however many National Central Bank heads and six Executive Board members ECB announces the target rate and takes questions from the media To stay at a manageable size as new countries join, the Governing Council will be on a system of rotation

ECB Independence Most independent in the world Members of the Executive Board have long terms (8 years) Determines own budget Less goal independent compared to the Fed  Price stability Charter cannot by changed by legislation; only by revision of the Maastricht Treaty ndence/html/index.en.html

Bank of Canada 1934 Inflation target since 1991 Target range 1- 3 percent Monetary Policy aimed at mid-point: 2% Less goal independence than Fed  flation_target.html (Follow this link and read the BOC statement) flation_target.html

Bank of England 1694 Least independent up to Interest rate policy determined by chancellor of the Exchequer. Policy now with the Bank, but can be overridden by the government. Inflation target – 2 percent. aspx aspx

Central Bank Independence and Macro Performance in 17 Countries