stephen g. cecchetti kermit l. schoenholtz the structure of central banks: the federal reserve and...

Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ

The Structure of Central Banks: The Federal Reserve and the European

Central BankCopyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter Sixteen

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Introduction

• Between 1870 and 1907, the nation experienced 21 financial panics of varying severity.

• During the Panic of 1907, an astonishing two-thirds of banks founds themselves temporarily unable to redeem deposits.

• In the intervening centuries, Europeans had developed a system of central banks. American had not.

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Introduction

• The prevailing philosophy of many 19th-century Americans was that centralized government of any form should be kept to a minimum.

• But punishing effects of frequent financial panics led people to reconsider the merits of a powerful central banks.

• In 1913, Congress passed the Federal Reserve Act.• This created the U.S. Federal Reserve System.

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Introduction

• While central banking had stabilized European financial systems before 1900, the 20th century was another story.

• Europe experienced high inflation rates, low growth, high and volatile interest rates, and unstable exchange rates.

• After two world wars, governments’ free spending led to unrelenting fiscal deficits.

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Introduction

• Leaders came to believe that the only way to ensure both political and economic stability was to forge closer ties among the continent’s countries.

• The result was the European monetary union, with its common currency, the euro, and its central bank, the European Central Bank (ECB).

• This chapter examines these two central banks and how their structure helps them to meet their objectives.

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The Structure of the Federal Reserve System

• The Federal Reserve Act established a system that is composed of three branches with overlapping responsibilities:• Twelve regional Federal Reserve Banks, distributed

throughout the country;

• A central governmental agency, called the Board of Governors of the Federal Reserve System, in Washington, D.C.; and

• The Federal Open Market Committee.

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• In addition, a series of advisory committees make recommendations to the board and the Federal Reserve Banks.

• Finally, there are the private banks that are members of the system.

• This complex structure diffuses power in a way that is typical of the U.S government.• It creates a system of checks and balances that

reduces the tendency for power to concentrate at the center.

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• 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.

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The Federal Reserve Banks

• The Federal Reserve Bank of New York has the largest gold vault in the world.• All of this gold belongs to foreign countries and

international organizations like the International Monetary Fund.

• It is also the largest of the 12 Federal Reserve Banks which together with their branches form the heart of the Federal Reserve System.• All 12 have cash vaults, but only New York has

gold.

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The Federal Reserve System:

The Twelve Districts

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• The lines separating the regions for the Federal Reserve System were drawn in 1914, so they represent population density at that time.

• Politicians decided that no district should coincide with a single state.

• The purpose of this is twofold:1. To ensure that every district contains as broad a

mixture of economic interests as possible, and

2. To ensure that no person or group can obtain preferential treatment from the Reserve Bank.

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• Reserve Banks are part public and part private.• They are federally chartered banks and private,

nonprofit organizations, owned by the commercial banks in their districts.

• They are overseen by both their own boards of directors and the Board of Governors.

• The method for choosing the nine members of the boards of directors ensures the inclusion of not only bankers but other business leaders and people who represent the public interest.

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• Six directors are elected by the commercial bank members.

• The remaining three are appointed by the Boards of Governors.

• Each Reserve Bank has a president who is appointed for a five-year term by the bank’s board of directors with the approval of the Board of Governors.

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• The Government’s Bank• Issues currency,

• Maintains the Treasury’s account, and

• Manages the Treasury debt.

• The Bankers’ Bank• Holds Reserve Deposits,

• Operates the Payments System,

• Makes Discount Loans at the Discount Rate,

• Supervises and regulates financial institutions, and

• Collects Data.


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Only the New York Fed Branch:•Auctions Treasury Securities,•Provides Foreign Government Services,•Completes Monetary Policy Operations, and•Runs Fedwire: Large Value Interbank Funds Transfer System.

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• The Federal Reserve’s own portfolio is managed at the Federal Reserve Bank of New York through what we called open market operations.

• In the crisis of 2007-2009, the Federal Reserve Bank of New York also operated a variety of special new liquidity and credit facilities that supplied funds to intermediaries and allowed with Fed to acquire a portfolio of non-Treasury assets.

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• Finally, the Reserve Banks play an important part in formulating monetary policy:• Through their representation on the Federal Open

Market Committee (FOMC), and

• Through their participation in setting the discount rate.

• The discount rate is the interest rate charged on loans to commercial banks.

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• The Federal Reserve Act specifies that the discount rate is to be set by each of the Reserve Bank’s board of directors, with approval of the Board of Governors.• Technically, it is done this way.

• However, it is set automatically at a premium above the overnight interest rate that the FOMC controls.• The directors have virtually no say over the

discount rate.

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The Board of Governors

• The seven members of the board, who are called governors, are appointed by the president and confirmed by the U.S. Senate for 14-year terms.

• The long terms are intended to protect the board from political pressure.

• The terms are staggered limiting any individual president's influence over the membership.

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• The board’s membership usually includes academic economists, economic forecasters, and bankers.

• No two governors can come from the same Federal Reserve district.

• The Federal Reserve Act explicitly requires “a fair representation of the financial, agricultural, industrial, and commercial interests.”

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• Duties of the governors are to:• Set the reserve requirement,

• Approve or disapprove discount rate recommendations,

• Administer consumer credit protection laws,

• Supervise and regulate the Reserve Banks,

• Along with the Reserve Banks, regulate and supervise the banking system,

• Invoke the emergency powers to lend to nonbanks,

• Analyze financial and economic conditions, and

• Collect and publish detailed statistics.

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• The seven governors do not have their own support staff.

• They request help and information from the managers of various departments, who assign individuals to specific tasks.

• The managers answer to the chair of the Board of Governors.

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• Treasury Direct allows individuals to purchase U.S. Treasury securities without the use of a broker or dealer.• With as little as $1000 you can start an account and

purchase bonds, notes, or bills through the Fed.

• You do it at the auction using a noncompetitive bid.• This guarantees you will receive the bond you want

at the average auction price.

• The Fed will sell your bonds at the highest market price available.

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The Federal Open Market Committee

• When the press discusses the Fed, their focus is generally on the Federal Open Market Committee (FOMC).• This group sets the interest rates 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

• Four Reserve Bank presidents.

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• 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.

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• The FOMC could control any interest rate, but it chooses to control the federal funds rate.• This is the rate banks charge each other for

overnight loans on their excess deposits at the Fed.

• By controlling the federal funds rate, the FOMC influences real growth.

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• The FOMC currently meets 8 times a year.• During times of crisis, the committee can

confer and change policy over the telephone.• Because these “inter-meeting” policy shifts signal

the financial markets that the FOMC believes conditions are dire, they are reserved for extraordinary times.

• The financial crisis of 2007-2009 prompted 12 unscheduled FOMC meetings.

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• The primary purpose of a meeting is to decide on the target interest rate.

• The FOMC itself does not engage in the financial market transactions that are required to keep the market federal funds rate near this target or to manage the Fed’s portfolio.

• That is the job of the system open market account manager who works for the Federal Reserve Bank of New York.

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• Three important documents are distributed to all attendees prior to each meeting:• The beige book, • The green book, and• The blue book.

• The beige book is a compilation of anecdotal information about current business activity.• This is the only FOMC document that is released to

the public before the meeting.

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• The green book contains the Board staff’s economic forecast for the next few years.

• The blue book is a discussion of financial markets and current policy options.

• Both the blue and green books are distributed electronically the week before the meeting.

• They are both treated as secret documents and are not released to the public for 5 years after the meeting.

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• An FOMC meeting is a formal proceeding that can be divided into two parts, each beginning with a staff report followed by a round of discussion that includes all the meeting’s participants.• There is a specific order in which people speak at

these meetings.

• Three weeks after the meeting, detailed minutes summarizing the deliberations are released on the FOMC’s public Web site.

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• To see where the committee’s power lies and who controls interest-rate decisions, we can look at a few things.

1. The chair is the voice of the Fed.

2. The governors make up a majority of the committee.

3. Beyond the beige book, the most important information regularly distributed to all committee members are the green and blue book both prepared by the Federal Reserve Board staff, controlled by the chair.

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4. The chair sets the agenda for FOMC meetings, determines the order in which people speak, and proposes the FOMC policy statement.

5. Although votes are made public immediately after the meeting, committee members observe a blackout period from a week prior to a week after the meeting.

• And don’t forget the Board of Governors controls the Reserve Banks’ budgets and salaries of their presidents.

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• The chair of the Fed is the FOMC’s most important member.• Listen to this person to see what the FOMC is going

to do.

• While the chair is very powerful, the committee structure provides an important check on his/her power.• Even two dissents on an FOMC votes are unusual.

• Three dissents would raise doubts about the chair’s leadership.

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User’s Guide to the Fed

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• As the financial crisis deepened in 2008, the range of FOMC policy actions broadened.

• The form of the FOMC statement released at the end of the FOMC’s regularly scheduled meetings changed markedly.

• Interpreting these statement takes some practice, especially in such extraordinary circumstances as a financial crisis.

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Assessing the Federal Reserve System’s Structure

• In the last chapter we said that an 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 clearly.

• Let’s evaluate the Fed using these criteria.

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Independence from Political Influence

• There are three criteria for judging a central bank’s independence:• Budgetary independence,

• Irreversible decisions, and

• Long terms.

• The Fed meets each of these.

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Independence from Political Influence

• The Fed controls its own budget.• Their 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.

• Interest rate changes are implemented immediately and can be changed only by the FOMC.

• The terms of the governors are 14 years, chair’s term is 4 years, and Reserve Bank presidents serve for 5 years.

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Decision Making by Committee

• The Fed clearly makes decision by committee, because the FOMC is a committee.

• While 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.

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Accountability and Transparency

• The FOMC releases huge amount of information to the public:• The beige book,

• Announcement of policy decision with explanatory statement,

• Detailed minutes of the meeting 3 weeks later,

• Word-for-word transcript 5 years later,

• Quarterly reports of the committee participants’ outlook for economic growth and inflation over the next 3 years,

• 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.

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• A few things are missing from the Fed’s communications:

1. There is not regular press conference, nor any real questioning of the chair on the FOMC’s current policy stance.

2. The inputs into the decision-making process and the meeting transcript are not made pubic until five years after the fact.

3. The fact that the committee has been hesitant to state its objectives clearly and concisely hampers communication.

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• Two events provide the foundation for 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.

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Policy Framework

• The Congress of the U.S. 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.”

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• Prior to becoming chairman, Ben Bernanke argued that the best way to make monetary policy is to announce a specific numerical objective for inflation over some time horizon.

• So far, the FOMC has moved closer to this approach by publishing the committee participants’ long-term inflation forecasts.

• However, the FOMC still does not publish a target that represents the committee’s consensus.

Policy Framework

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• The Fed does its best to stabilize the economy.• The stock market goes up and down regardless

of what the Fed does.• The Fed does not control the stock market and

will react to movements only in so far as they comprise its inflation and growth objectives.

• No one can eliminate the risk that is inherent in an investment - not even the most powerful central bank in the world.

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The European Central Bank

• On January 1, 1999, the majority of Western European countries adopted a common currency.

• Purchases are made in euros, and monetary policy is the job of the European Central Bank (ECB).

• By 2010, the euro had become the currency of 16 countries.

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• The agreement to form a European monetary union was formalized in the Treaty of Maastricht.

• It ultimately led to the creation of the European system of Central Banks (ESCB).• The ESCB is composed of the National Central

Banks (NCBs) in the 27 countries in the European Union.

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• The ECB and the NCBs of the 16 countries that participate in the monetary union make up what is known as the Eurosystem.• They share a common currency and common

monetary policy.

• We will refer to the institution that is responsible for monetary policy in the euro area as the European Central Bank.

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Organizational Structure

• The eurosystem mirrors the structure of the Federal Reserve System in several ways.• There is 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.

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• The Executive Board has a president and a vice president who play the same role as the Fed’s chair and vice chair.

• Executive Board members are appointed by a committee composed of the heads of state of the countries that participate in the monetary union.

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• 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 in the economy, and

• 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.

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• There are several important differences between the Fed and the ECB.

1. The ECB does not supervise and regulate financial institutions.

2. The implementation of monetary policy is accomplished at all the national central banks, rather than being centralized as in the U.S.

3. The ECB’s budget is controlled by the National Central Banks, not the other way around.

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• The focus of the ECB’s activity is on monetary policy.

• The Governing Council is composed of the six Executive Board members and the governors of the 15 central banks in the euro area.

• Meetings are held monthly.• Decisions are made by consensus; no formal

votes are taken.• The Governing Council members are charged with

setting policy for the euro area as a whole, regardless of economic conditions in the individual countries.

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• A number of important safeguards were included in the Treaty of Maastricht to ensure the central bank’s independence.

1. There are terms of office.

2. The ECB’s financial interests must remain separate from any political organization.

3. The treaty states explicitly that the Governing Council cannot take instructions from any government, so its policy decisions are irreversible.

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• There will be more countries who want to enter the monetary union and some difficult decisions must be made.• ECB’s membership would be 6 executive board

members and one representative from each of the member countries - a possible total of 33 members.

• The Governing Council of the ECB has adopted a complex system of rotation to be implemented when country membership reaches 19 states.• It bears a passing resemblance to the system used

by the FOMC.

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• Like the Fed, the ECB distributes large volumes of information in all of the ECB’s official languages.

• Included are:• A weekly balance sheet;

• A monthly statistical bulletin;

• An analysis of current economic conditions;

• Biannual forecasts of inflation and growth;

• Research reports relevant to current policy; and

• An annual report.

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• The most important aspect of the ECB’s communication strategy concerns statements about the Governing Council’s policy deliberations.

• Following each of the Governing Council’s monthly meetings, the president and vice president of the ECB hold a news conference.• This contrasts the statement and refusing to answer questions

after its meeting by the FOMC.

• However, the ECB does not make minutes public for 20 years.

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• In assessing whether the ECB’s communications strategy is sufficient, we need to ask two questions:

1. Does the information that is released minimize the extent to which people will be surprised by future policy actions?

2. Does it hold policymakers accountable for their decisions?

• The answer is yes to both questions.

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• Ben Bernanke wrote about the virtues of central banks adopting inflation targets.

• The adoption of a new policy framework depends on building political support both among the members of the FOMC and in the U.S. Congress.

• Under Chairman Bernanke, the FOMC gradually adjusted its procedures to become more like those of an inflation-targeting central bank.

• Has the FOMC announced an explicit inflation target?

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The Price Stability Objective and Monetary

Policy StrategyThe 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.”

• This includes the objective of sustainable and non-inflationary growth.

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Policy Strategy• The Treaty is widely understood to place

priority on price stability as the top objective for the ECB.

• The Governing Council’s response has been to explain its interpretation of the statement and describe the factors that guide its policy decisions.

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Policy StrategyThe strategy has two parts:

1. There is a numerical definition of price stability, and

2. The Governing Council announces its intention to focus on a broad-based assessment of the outlook for future prices, with money playing a prominent role.

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Policy Strategy• The ECB’s Governing Council defines price

stability as an inflation rate of close to, but less than, 2 percent, based on a euro-area-wide measure of consumer prices.• This is the harmonized index of consumer prices

(HICP) and is similar to the CPI.

• It is the average of retail price inflation in all the countries of the monetary union, weighted by the size of their gross domestic products.

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Policy Strategy• This arrangement has important implications

for monetary policy operations, because there will surely be times when the proper policy for Ireland is to raise interest rates but the proper policy for Germany is to lower them.• Given Ireland’s relative size, a change in inflation

or growth there has little impact on the euro area as whole.

• The same is true for a number of other small countries in the union.

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Policy Strategy• The fact that the economically large countries

matter much more than the small ones can affect the dynamics of the governing council’s policymaking.

• While the governing Council’s job is to stabilize prices in the euro area as a whole, one wonders whether activities in the smaller countries might have undue influence on its policy decisions.

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Policy Strategy• Evidence strongly suggests that the ECB is

doing the job it is supposed to do.• The Governing council’s policy has been

appropriate to the euro area.• It has not been skewed toward smaller countries’

concerns.

• The specificity of the price stability objective holds policymakers accountable.• It limits discretion in their decision making.

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• The designers of the ECB introduced a rule that forbids the ECB from directly helping a government facing financial distress.• This was the so-called no-bailout clause of the

Maastricht Treaty.

• In 2010, very large fiscal deficits of several euro-area governments led to a widening of yield spreads of their debt over German debt.

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• Given the no-bailout rule, the burden of preventing a disruption of sovereign borrowing falls on euro-area fiscal leaders.

• In the spring of 2010, after posting the second largest budget deficit of any euro-area country, the Greek government experienced significant problems borrowing.

• Euro-area nations teamed up with the IMF to offer Greece large-scale loans at a cost below market yields.

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• This was, of course, provided that the Greek government implement a set of stringent budget reforms proposed by the IMF.

• It remains to be seen how successful the program will be in securing long-run stability in the region.

Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ

The Structure of Central Banks: The Federal Reserve and the European

Central BankCopyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

End ofChapter Sixteen

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