10/21/2018. Chapter 16. Learning Objectives. Central Banks. Functions and objectives of central banks. Features of an effective central bank.

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1 Chapter 16 Central Banks (in the world today) and the Federal Reserve System Learning Objectives Functions and objectives of central banks. Features of an effective central bank. Federal Reserve organization and policy framework. ECB organization and policy framework. Central Banks There are about 170 central banks in the world today. Nearly every country has one. Interestingly, central banking is largely a 20 th - century phenomenon. In 1900, only 18 countries had central banks. When the Soviet Union collapsed in 1990, 12 of the 15 republics had central banks within a year 1

2 Web Links Two Roles of the Central Bank The Government s Bank, The Banker s Bank Government s Bank Manage the finances of the government. Control the availability of money and credit. They create money. Conduct monetary policy, expansionary/tight Role of the Central Bank - The Banker s Bank Important day-to-day functions of the central bank Manage the payments system (settle interbank payments). Provide loans during times of financial stress (the lender of last resort credit facilities). Oversee commercial banks and the financial system to ensure confidence in their soundness (regulatory oversight). 2

3 What a Central Bank is Not In the US, the Fed does not control securities markets. It does trade in the bond market. The Fed does not control the government s budget. That is determined by Congress and the president through fiscal policy. The Fed only acts as the Treasury s bank. The Primary Objectives of all Central Banks - Stability 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? The Federal Reserve has a dual mandate. The boxed items on the previous slide In the short run, price stability can conflict with the goal of growth and high employment. Other countries elevate the goal of price stability ECB has a hierarchical mandate, price stability first, then growth. Other countries have a legislative price stability mandate inflation targeting. 3

Why is Low and Stable Inflation Desirable? Money ceases to function as a store of value, unit of account or medium of exchange with high inflation. How Low is Low? No agreement on this.

4 Why is Low and Stable Inflation Desirable? Money ceases to function as a store of value, unit of account or medium of exchange with high inflation. How Low is Low? No agreement on this. Zero inflation is probably too low. - risk of deflation which in turn results in defaults on loans and a threat to the health of banks. - inflation measures are biased. Countries with legislated explicit inflation targets set at 2%. The US does not have an explicit inflation target. but implicit at 2%. High & Stable Real Growth The idea is that there is some long-run normal level of production called potential output, which depends on things like Technology, The size of the capital stock, The number of people who can work, and hours worked. Growth in these inputs leads to growth in potential output -- sustainable growth. 4

5 4-quarter Percentage Change High & Stable Real Growth The economy cycles above and below this long-run potential growth. A role of the central bank is to change interest rates to adjust short-run cyclical growth. In the long run, stability leads to higher growth. High & Stable Real Growth Data shows stable countries grow faster US GDP Growth Rate from 1960 Real GDP Growth

6 Financial System Stability The Fed was established in 1913 to stop the financial panics that plagued the U.S. during the late 19th and early 20th centuries. Panic of 1907 Interest-Rate and Exchange-Rate Stability In the US, these goals are secondary to those of low inflation, stable growth, and financial stability. In the hierarchy, interest-rate stability and exchange-rate stability are means for achieving the ultimate goal of stabilizing the economy. They are not ends unto themselves. Creating a Successful Central Bank Four requirements to be successful: independent of political pressure, make decisions by committee, transparent in communicating its policy actions and accountable to the public, operate within an explicit framework that clearly states its goals and makes clear the trade-offs among them. 6

7 Independence To keep inflation low, monetary decisions must be made free of political pressure. Politicians have an incentive to create short-term prosperity (print money) at the expense of inflation tomorrow. Central bank policy makers must think in terms of longterm inflation. Longer time horizon needed to avoid inflation bias Knowing the tendencies of politicians, governments have moved responsibility for monetary policy into a separate, largely apolitical, institution. What is needed for Independence 1. Monetary policymakers must be free to control their own budgets. 2. Policies must not be reversible by people outside the central bank. The U.S. Federal Open Market Committee s decisions cannot be overridden by the President, Congress or the Supreme Court. 7

8 Decision Making by Committee Pooling the knowledge, experience, and opinions of a group of people reduces the risk that policy will be dictated by an individual s quirks. Vesting so much power in one individual also poses a legitimacy problem. Therefore, monetary policy decisions are made by committee in all major central banks in the world. Accountability and Transparency Politicians establish a set of goals. Policymakers publicly report their progress in pursuing those goals. Explicit goals foster accountability and disclosure requirements create transparency. The institutional means for assuring accountability and transparency differ from one country to the next. Explicit Policy Framework Fed has a Dual Mandate Stable prices and maximum employment. ECB has a hierarchical mandate inflation first, growth second. A number of countries have explicit inflation targets set by politicians. 8

9 Federal Reserve System Recognize the historical context of the development of the Federal Reserve System. Describe the key features and functions of the Federal Reserve System. Assess the degree of independence of the Federal Reserve. Origins of the Federal Reserve System Resistance to establishment of a central bank 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 The Structure of the Federal Reserve System Twelve regional Federal Reserve Banks, distributed throughout the country; Board of Governors of the Federal Reserve System, in Washington, D.C.; and The Federal Open Market Committee. 9

10 The Structure of the Federal Reserve System All national banks are required to belong to the Federal Reserve System. State banks that receive their charters from individual state banking authorities have the option of joining, but fewer than 20% do. The Federal Reserve System: The Twelve Districts The 12 Federal Reserve Banks Reserve Banks are part public and part private. Federally chartered banks Nonprofit - owned by the commercial banks in their districts. 10

11 The 12 Federal Reserve Banks Nine directors Six directors elected by the commercial bank members of the Reserve Bank Three directors representing the member banks Three representing the public. Three directors appointed by the Boards of Governors. Each Reserve Bank has a president who is appointed for a five-year term The Federal Reserve Banks Play an important role in formulating monetary policy: Representation on the Federal Open Market Committee (FOMC), and Setting the discount rate. The New York Fed: Executes Open market Operations. Runs Fedwire: Interbank Funds Transfer System The Board of Governors The seven members, appointed by the president and confirmed by the U.S. Senate for 14-year terms. The long terms are intended to foster independence by protecting the board from political pressure. The terms are staggered limiting any individual president's influence over the membership. 11

12 The Board of Governors Duties of the governors are to: Set the reserve requirement, Approve or disapprove discount rate recommendations, Rule-writing agency for consumer credit protection laws (with enforcement by the Consumer Financial Protection Bureau created by the Dodd-Frank Act) Along with the Reserve Banks, regulate and supervise the banking system, Analyze financial and economic conditions, and Collect and publish detailed statistics. The Federal Open Market Committee When the press discusses the Fed, its the Federal Open Market Committee (FOMC). sets the interest rates and adjusts the Fed s balance sheet to control the availability of money and credit to the economy. It has existed since 1936 and has 12 voting members: The seven governors, The president of the Federal Reserve Bank of New York, and A rotating selection of 4 of the remaining 11 Reserve Bank presidents. The Federal Open Market Committee The chair of the Board of Governors chairs the FOMC. The committee s vice chair is the president of the Federal Reserve Bank of New York. While only 5 of the 12 Reserve Bank presidents vote at any one time, all of them participate in the meeting. 12

13 The Federal Open Market Committee Controls the federal funds rate. This is the rate banks charge each other for unsecured overnight loans on their excess deposits at the Fed. Intent - by controlling the federal funds rate, the FOMC influences market interest rates and real economic growth. The Federal Open Market Committee The FOMC currently meets 8 times a year. Committee can confer and change policy over the telephone. The financial crisis of prompted 12 unscheduled FOMC meetings. The primary purpose of a meeting is to decide on the target interest rate. Gives directive to the system open market account manager who works for the Federal Reserve Bank of New York to carry out OMO. Assessing the Federal Reserve System s Structure Recall, effective central bank is one in which: Policymakers are independent of political influence, Make decisions by committee, Are accountable and transparent, and State their objective(s) clearly. Evaluate the Fed using these criteria. 13

14 Independence from Political Influence Three criteria for judging central bank independence: Budgetary independence, Irreversible decisions, and Long terms in office. The Fed meets each of these. The Fed controls its own budget. Earn substantial revenue comes from interest on government securities it holds and fees charged to banks for payments system services. Typically 95% of its income is returned to the U.S. Treasury each year. Financially Independent In 2015, Earned about $113 Billion on securities. minus interest on reserves and other expenses of $13 Billion, Turned $100 Billion over to Treasury and 2017, sent the Treasury $91.5 and $

15 Decision Making by Committee The Fed clearly makes decision by committee - the FOMC The chair of the Board of Governors may dominate policy decision, the fact that there are 12 voting member provides an important safeguard against arbitrary action. Accountability and Transparency The FOMC releases huge amount of information to the public: Announcement of policy decision and reasoning, Detailed minutes of the meeting 3 weeks later, Word-for-word transcript 5 years later, Twice-yearly Monetary Policy Report to the Congress, The chair s appearance before Congress to discuss the state of the nation s economy, and Numerous speeches given by the chair, other governors and Reserve Bank presidents. Two Events Adding to Fed Independence: 1. In 1935, political appointees were removed from the Federal Reserve Board, and the FOMC was created. 2. In 1951, President Truman supported the Fed s refusal to purchase Treasury securities that the Secretary of the Treasury requested they buy. The president, the secretary of the Treasury, and the Federal Reserve chair reached an accord and issued a joint announcement establishing the FOMC s independence in setting interest rates and controlling the rate of monetary expansion. 15

16 Fed s Policy Framework The Congress has set the Fed s objectives: The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. Fed s Policy Framework The Dual Mandate means the Fed has instrument and goal independence Instrument OMO, reserve requirement, discount rate Dual Goals - Should the Fed Be Independent? The Case for Independence The strongest argument for an independent central bank not influenced by political pressure which could be inflationary. The Case Against Independence Proponents of a Fed under the control of the president or Congress argue it is undemocratic to have monetary policy (which affects almost everyone in the economy) controlled by an elite group that is responsible to no one. Undemocratic Unaccountable Can t coordinate fiscal and monetary policy 16

17 European Central Bank(ECB) European Monetary Union began January 1, 1999 Euro notes and coins began circulation January 1, of 28 countries in the European Union use the Euro o/html/map.en.html The European Central Bank The agreement to form a European monetary union was formalized in the Treaty of Maastricht. European Central Bank (ECB) is the institution that is responsible for monetary policy in the euro area. The ECB and the NCBs of the 19 countries that participate in the monetary union make up what is known as the Eurosystem. They share a common currency and common monetary policy. ECB Structure The ECB mirrors the structure of the Federal Reserve System in several ways. A six-member Executive Board of the ECB, similar to the Board of Governors; The National Central Banks play many of the same roles as the Federal Reserve Banks; and The Governing Council formulates monetary policy as the FOMC does. 17

18 ECB Structure The Executive Board has a president and a vice president who play the same role as the Fed s Chair and Vice Chair. ECB executive board members have 8 year terms and are appointed by a committee composed of the heads of state of the countries that participate in the monetary union. Organizational Structure The ECB and the NCBs together perform the traditional operational functions of a central bank. They use interest rates to control the availability of money and credit They are responsible for the smooth operation of the payments system and the issuance of currency. The National Central Banks continue to serve as bankers to the banks and governments in their countries. Monetary policy ECB Structure The Governing Council is composed of the 6 Executive Board members and the governors of the 19 central banks in the euro area. Meetings are held monthly to determine policy Voting is on a rotating basis. 18

19 Organizational Structure The Governing Council is charged with setting policy for the benefit of the euro area as a whole, regardless of economic conditions in the individual countries. Decisions are made by formal votes of the Council, but are not published. Ensure that Governing Council members focus on setting policy for the euro area as a whole Organizational Structure Important safeguards were included in the Treaty of Maastricht to ensure the central bank s independence. There are terms of office (8 year term). The treaty states explicitly that the Governing Council cannot take instructions from any government, so its policy decisions are irreversible. The Price Stability Objective and Monetary Policy Strategy The Treaty of Maastricht states: 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 ESCB shall support the general economic policies in the Community. 19

20 The Price Stability Objective and Monetary Policy Strategy The ECB s Governing Council defines price stability as an inflation rate of close to 2 percent, based on a euro-area-wide measure of consumer prices. 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 is stated primary goal Charter cannot by changed by legislation; only by revision of the Maastricht Treaty ndence/html/index.en.html Countries with Explicit Inflation Targets 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 lation_target.html (Follow this link and read the BOC statement) 20

21 1694 Bank of England 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. ome.aspx 21

The Federal Reserve Banking System. K. Maldonado IB Business & Finance John A. Ferguson Senior High School

The Federal Reserve Banking System K. Maldonado IB Business & Finance John A. Ferguson Senior High School Why a Federal Reserve System? During the early twentieth century, there was a series of panics