FNCE 4070Financial Markets andInstitutions

Lecture 7

Central Banking and the Conduct of Monetary Policy

What are These Central Banks and Who are These Central Bankers?

Why Study Central Banking? Answer: Central bank actions have significant

impacts on financial markets and specifically on: (1) interest rates (the cost of borrowing and the return on

investing). (2) financial asset prices (stocks, bonds, foreign exchange)

Thus we need to know something about central banks: How do central banks operate in financial markets? How can we monitor the potential for changes in central

bank actions? Understanding these issues will add to our understanding of (1) and

(2) above.

Who Runs a Country’s Central Bank? Central Banks may be either:

(1) government owned and government controlled or (2) run under regulations that are specifically created to prevent extensive

government interference. In most countries -- especially in the developing world -- the central

bank is owned and controlled by the national government and, thus, has the potential for a minimal degree of autonomy from that government. This situation, unfortunately, allows for the possibility of government

interference in monetary policy. As one example, the Central Bank of China, the People's Bank of

China (PBOC) enjoys little operational independence. Unlike Western central banks, the PBOC does not have the final

word on adjusting interest rates or the value of the yuan. The basic course of monetary and currency policy is set by the State Council, China's cabinet, or by the Communist Party's ruling Politburo.

Central Banks in Major Countries In the major countries of the world, however, central

banks generally operate “independent” of their respective governments. Some of these banks are owned by their governments while others are not. The Bank of England was nationalized in 1946; however in 1997

it became an “independent” public organization, still wholly owned by the Government, but with “independence” in setting monetary policy to achieve government mandated inflation target.

The Federal Reserve, on the other hand, is “owned” by the 12 district banks and it is considered an independent central bank because: Its decisions do not have to be ratified by the President or anyone else in the

executive or legislative branch of government, It does not receive funding appropriated by Congress, and The terms of the members of the Board of Governors span multiple

presidential and congressional terms.

Reducing Government Control of Central Banks Removing government control is designed to prevent

political interference in the monetary policy process. In reality, however, the degree of true independence, or

separation from government involvement, varies even among these countries. Some governments (e.g., the U.K., Australia, and Canada) are

actively involved in setting specific inflation targets for their central banks.

Others such as the ECB’s operate within an inflation target as implied in its original charter.

The Federal Reserve is probably an example of a central bank with the greatest separation from government involvement.

Major Central Banks Independence

Central Bank (Date Founded) Date of Independence* Federal Reserve (1913): 1913** Bank of England (1694): 1997*** Bank of Japan (1882): 1998**** European Central Bank (1999): 1999*****

*Recognized date of “separation from government influence.” **Granted in the 1913 Federal Reserve Act. ***Following the election of the new Labor Government in May 1997. ****Under revisions to the Bank of Japan Law *****As noted in the Maastricht Treaty (1993) and specified in the

Bank’s charter.

Should Central Banks be Independent? Over the years, there has been growing debate as to the

most efficient and effective arrangement for central banks. Case for Central Bank Independence:

Independent Central Banks are more likely to have longer run objectives while politicians may have shorter term objectives.

Independence minimizes a “political” (i.e., election induced) business cycle. A 2005 study suggested that political business cycles have been

concentrated in the Latin America region. Empirical work suggests that countries with the most independent

central banks do the best job of controlling inflation and achieving economic growth (see slides which review this evidence).

Case against Central Bank Independence Central Bank should be accountable (at least in terms of their

goals) to their general populations (and perhaps less so in terms of their policies to achieve goals).

Hinders coordination of monetary and fiscal policy.

How Independent are Central Banks Today?

Some central banks which we characterized as “independent” have their inflation goals set by their national governments, but are given freedom with regard to the use of policy instruments to achieve those goals.

Bank of England: “The Bank’s monetary policy objective is to deliver price stability. Price stability is defined by the Government’s inflation target of 2%. The 1998 Bank of England Act made the Bank independent to set interest rates.” (Bank web-site).

Other examples: Brazil, China, Mexico

Variations on Inflation Target Process Switzerland: the central bank has authority to set its

inflation target (currently at no more than 2% a year for the medium to long term).

ECB governing council sets its own inflation target (currently 2%) consistent with the 1992 Maastricht Treaty’s stated goal of “price stability.”

Canada and New Zealand’s inflation targets are determined jointly by their respective governments and their central banks.

Both the U.S. and Japan, where neither the Fed nor the BOJ has specific mandated government (inflation) goals.

Central Bank Independence and Inflation, 1955-1988

Central Bank Independence and Inflation, 1973-1988

Central Bank Independence and Economic Growth, 1973-1988

Visualizing the Path of Central Bank Monetary Policy Monetary Policy Tools (Policy Instruments)

(1) Open market operations (buying and selling debt) (2) Discount window (borrowing) facilities (3) Reserve requirement adjustments (4) Intervention in foreign exchange markets

Operational Targets (Targets of Policy Actions) Monetary aggregates (money supply measures) Financial market variables (short interest rates, exchange rates)

Macroeconomic Target (Ultimate Goals of Policy) Inflation Economic growth Employment External trade

Question: What is the Most Commonly Used of Policy for the Fed? Monetary Policy Tools (Policy Instruments)?

(1) Open market operations (2) Discount window (borrowing) facilities (3) Reserve requirement adjustments (4) Intervention in foreign exchange markets

Operational Targets (Targets of Policy Actions) Monetary aggregates (money supply measures) Financial market variables (short interest rates, exchange rates)

Macroeconomic Target (Ultimate Goals of Policy) Inflation Economic growth Employment External trade

Historical Use of Fed Policy Instruments 1913 Act: Major policy instrument was the discount

facility and the discount rate (“rediscounting of commercial paper”). Federal Reserve Act of 1913 actually had no provision

for changes in reserve requirements and open market operations as a policy tool were not yet “discovered.” When discount loans (which were a source of income for

the Fed) fell in 1920, the fed started to purchase seasoned securities for income and as they did so they quickly realized that these “open market operations” were having a impact on bank reserves.

Thus, as a result, open market operations evolved into the major Fed instrument from this point on.

Open Market Operations (1) Open market operations: Purchases and sales of U.S.

Treasury and federal agency as specified by the Federal Open Market Committee (FOMC). A short term objective is specified in terms of a desired interest

rate (federal funds rate) and is conveyed to the Federal Reserve Bank of New York for implementation. Since 1995 the Fed has specified an explicit target level for the

federal funds rate. For specific targets since 1995, see:

http://www.federalreserve.gov/fomc/fundsrate.htm The FOMC has regular meeting scheduled approximately

every 6 weeks (8 times a year), although it can call an emergency meeting anytime. For scheduled meeting and minutes of meetings see:

http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm

Discount Facility (2) The discount rate: The interest rate charged to commercial

banks and other depository institutions on loans they receive from their regional Federal Reserve Bank.

Federal Reserve Banks offer three discount window programs to depository institutions: (1) primary credit, i.e., overnight, (current rate 0.75%) (2) secondary credit (to meet severe short term financial

difficulties (current rate 1.25%), and (3) seasonal credit, i.e., to smaller institutions in agricultural or

seasonal resort areas (current rate 0.20%) All discount window loans must be fully secured (usually with

Treasury securities). The term “discount rate” is normally applied to the rate on

primary credit loans. For current and historical discount rates see:

http://www.frbdiscountwindow.org/index.cfm

Relationship of Discount Rate to Fed Funds Rate

Historically, the discount rate was set below the federal funds rate. To discourage banks from borrowing at the discount

window and lending it out at a profit in the fed funds market, the Fed required a bank to prove it that a discount loan was its last option for securing needed funds.

In 2003, however, the Fed introduced a new policy by which the discount rate is now set above the fed funds rate. Since 2003, the discount rate has averaged 85 basis

points above the effective fed funds rate. See exhibits on next slide.

Fed Funds Rate and Discount Rate1995 - 2002 2003 - Present

Reserve Requirements (3) Reserve requirements: The amount of funds

(reserves) that a depository institution must hold in reserve against its specified deposit liabilities. Reserves can be held the form of vault cash or deposits with

Federal Reserve Banks. Reserves requirements are set against transaction

accounts (e.g., demand deposits, NOW accounts, etc), time deposits, and eurocurrency deposits.

Under the Monetary Control Act of 1980, the Fed can vary reserve requirement up to 14% on transaction accounts and up to 9% on all other deposits. This act also applies these reserve requirements to all

commercial banks, regardless of Fed membership. (See next slide)

For historical and current reserve requirements see:http://www.federalreserve.gov/monetarypolicy/reservereq.htm

Monetary Control Act (MCA) of 1980 Before the passage of the MCA in 1980, only commercial

banks that were members of the Federal Reserve System had to meet the Fed's reserve requirements.

State-chartered commercial banks that were not Federal Reserve members had to meet their respective state's reserve requirements, which typically were lower. As a result, many commercial banks were dropping their Federal

Reserve membership in favor of state charters. And, as banks did so, Federal Reserve member bank transaction

deposits fell from nearly 85% of total U.S. transaction deposits in the late 1950s to 65% by the late 1970s.

The MCA resolved this problem by authorizing the Fed to set reserve requirements for all depository institutions, regardless of Fed membership status.

Limited Use of Reserve Requirements as a Monetary Policy Tool Since 1980, there have been only a handful of

policy-related reserve requirement changes in the United States. As two examples: In December 1990, the Fed cut the requirement on

time deposits and on Eurocurrency deposits from 3% to 0%. The Fed suggested that the cut would reduce banks' costs,

"providing added incentive to lend to creditworthy borrowers.“ In April 1992, the Fed cut the requirement on

transaction deposits from 12% to 10%. The Fed suggested that this cut would put banks "in a better

position to extend credit."

Question: What Operational Target Does the Fed Use? Monetary Policy Tools (Policy Instruments)

Open market operations

Operational Targets (Targets of Policy Actions)? Monetary aggregates (money supply measures) Financial market variables (short interest rates, exchange rates)

Macroeconomic Target (Ultimate Goals of Policy) Inflation Economic growth Employment External trade

Historical Use of Operational Targets by the Federal Reserve Interest Rate Targets: In the years immediately after WW II, the Federal Reserve

agreed to “peg” interest rates at very low levels (3/8% on Treasury bills and 2 ½% on Treasury bonds).

Fed agreed to this interest rate target as a way of holding down the Treasury’s war financing costs (see next slide)

In 1951, an agreement was reached between the Treasury and the Fed agreed that the Fed would no longer peg Treasury interest rates (agreement called the “The Accord”) .

In the 1950 and 1960s, the Federal Reserve decided to target money market conditions, and specifically short term interest rates.

Short Term Interest Rates After WWII

Historical Use of Operational Targets by the Federal Reserve Recall that in the 1970s, the U.S (as well as other industrial

countries) experienced very high inflation rates. During this time, under increasing criticism from “monetarists”

that central banks were unable control inflationary pressures, the shift was from interest rate targets to targeting of monetary aggregates, specifically various money supply measures (M1, M2, etc). Milton Friedman (1968): “Inflation is always and everywhere a monetary

phenomenon.” By the end of the 1970s, most major central banks had dropped

interest rate targets and adopted some form of monetary aggregate targeting; Bank of England in 1973 Bundesbank (Germany) in 1975 Bank of Japan in 1978 Federal Reserve October 6, 1979.

Short History of Money Supply Targeting The 1978 Humphrey-Hawkins Act mandated that the Fed set

annual targets for money supply and that the Fed Chairman report to Congress twice each year regarding these targets.

However, a monetary target was a appropriate only so long as its velocity (the rate of turnover of a dollar of the money supply) was stable over the long term. Unfortunately, the long term stability of money velocity, which was at

the core of monetarism, disappeared beginning in the late 1980s. In addition, there was concern that in targeting the money

supply, central banks were losing control over interest rates and these rates were becoming more volatile.

Velocity of Money

Volatility of Interest Rates in the 1980s

Return to Interest Rate Targets By the 1980s, central bank concern about the changing

velocity of money combined with the wide swings in interest rates which had been occurring, resulted in the “de-emphasis” this monetary aggregate approach.

Thus by the 1990s, central banks had shifted their operational target focus back to short term interest rates.

In July 1993, the Fed announced it was no longer using any monetary targets.

In the 1990s, most major central banks had abandoned monetary targets in favor of some short term interest rate as their operational target. Today’s rates are: Fed Reserve: The fed funds rate (rate for reserves in the interbank market). Bank of England: Official bank rate European Central Bank: Main refinancing rate Bank of Japan: Uncollateralized overnight call rate

Question: What is Fed’s Most Commonly Used Macroeconomic Target? Monetary Policy Tool

Open market operations (Buying and selling Treasury securities)

Operational Target Financial market variable (short term interest rates)

Macroeconomic Target? Inflation target Economic growth target Unemployment rate target Exchange rates target

Early U.S. Central Bank History Except for two failed attempts (1791 and 1816), the U.S.

operated without an effective central bank up until 1913. Prior to 1913, there were frequent economic recessions

and financial crises in the U.S. with the Bank Panic of 1907 finally convincing the government that a central bank was necessary.

On December 23, 1913, Congress passed and President Woodrow Wilson signed into law The Federal Reserve Act, establishing a central bank for the United States. The Act was also called the Glass-Owen Act.

The 1913 Act was to “provide for establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.” Note: There were no explicit macro economic goals in the 1913

Act and no mention of open market operations.

U.S. Economic Performance During the Early Fed Years

Changing Goals of the Federal Reserve In response to the unemployment crisis of the Great Depression, the U.S. Congress, in February 1946, passed the Full Employment Act: “The Congress hereby declares that it is the

continuing policy and responsibility of the Federal Government … to promote maximum employment, production and purchasing power.”

These new goals also become the goals of the central bank.

The 1970s -80s: A New Problem Recall, in the 1970’s,

global inflation became the major economic issue for industrial countries. Two distinct inflation peaks:

1973/74 and 1980/81. As a result, many central

banks turned their attention to inflation and some to the use of inflation targets as a macro economic goal. Begins with New Zealand

adopting an inflation target of 0 to 2% in March 1980.

Inflation in Industrial Countries, % per year

Adoption of Explicit Inflation Targets Early Adopters (with original target):

New Zealand: March 1990 (set at 0 to 2%) Canada: February 1991 (set at 1 to 3%) United Kingdom: October 1992 (set at 2%) Australia: January 1993 (set a 2 to 3%) Sweden: January 1993 (set at 2%) Finland: February 1993 (set at 2%) Spain: January 1995 (set at 3.5 to 4%)

Later Adopters (with original target) Euro-zone: Jan 1999 (set below, but close to, 2%) Poland: January 1999 (8 to 8.5%) Brazil: June 1999 (set at 8%) South Africa: 2002 (set a 3 to 6%)

Initial Response of the U.S. to High InflationU.S. Inflation

In 1977, additional mandates for the Federal Reserve were introduced with Congressional amendments to the Federal Reserve Act: The 1977 amendments required

the Board of Governors and the FOMC to "maintain the growth of 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.“

However, no explicit inflation targets were introduced at that time.

History of Macroeconomic Targets From a practical standpoint there are any number of

macroeconomic variable a central bank might target, including: A unemployment rate (has been proposed for South Africa) A real GDP growth rate An exchange rate (Bretton Woods, 1944 – 1971; U.K.: October 1990

– September 1992; Hong Kong and Singapore today) An inflation target

The use of exchange rate targets was popular among some central banks in the late 1980s/early 1990s. Bank of England adopted an exchange rate target in 1990.

As noted earlier, in March 1990, the Central Bank of New Zealand was the first to adopt an inflation target. Over the decade of the 1990s, a growing number of countries

adopted inflation targets From 4 countries in 1990 to 54 by 1998.

And in 2009 the U.S. followed with an announced “implied” inflation target of 2%

Case Study: Inflation Targeting in New Zealand

Note: GST refers to Goods and Services Tax New Zealand had informally “targeted” inflation at 0 to 2% beginning

in 1988; although in 1990 it was formally introduced into law with the New Zealand Act of 1989.

Inflation Targeting Impact on Interest Rates: New Zealand

Final Issue: Central Bank Transparency Transparency means that a central bank

provides the general public and financial markets with relevant information in an open, clear and timely manner.

Transparency is potentially important because it reduces uncertainty about a central bank’s intention. Helps the financial market establish “anchors”

critical to their expectations. Today, most central banks consider

transparency as crucial to their success. Monetary policy is assumed to be more effective when the

central bank provides the public with guidance on its objectives, activities and outlook.

Central Bank Transparency Many Central Bank web sites are now in English:

Visit: http://www.bis.org/cbanks.htm Many central bankers regularly talk to the “public.” Central Bank decisions and actions are published in a timely manner.

Federal Reserve Bank: Has eight scheduled meetings per year. A press statement is released immediately following each meeting. http://www.federalreserve.gov/fomc/#calendars

Bank of England Monetary Policy Committee meets the first Thursday of every month. The decisions on interest rates are announced at 12 noon immediately following the meeting. http://www.bankofengland.co.uk/monetarypolicy/decisions/decisions07.htm

Governing Council of the ECB meets on the first Thursday of each month with the decision on the key ECB interest rates is issued at 1:45 p.m. C.E.T. At 2:30 p.m. C.E.T. , the President and the Vice-President of the ECB hold a press conference to discuss the decision. http://www.ecb.int/press/govcdec/mopo/2007/html/index.en.html

Bank of Japan announce their interest rate decisions immediately following their meeting. http://www.boj.or.jp/en/mopo/mpmdeci/index.htm/

ECB and Bank of England Press Releases ECB:

http://www.ecb.int/press/html/index.en.html ECB Follow-up (With Q and A)

http://www.ecb.int/press/pressconf/2008/html/index.en.html

Bank of England: http://www.bankofengland.co.uk/publications/news/2008/index.htm

Measures of Central Bank Transparency Fed ECB UK Japan Canada NZ AU

Goal of Monetary Policy and Accountability              

Explicit Inflation Target Specified No Yes Yes No Yes Yes Yes

Inflation Target/Range  2%* <2% 2%  ---- 1-3% 1-3% 2-3%

Reports to Legislature (Accountability) Yes Yes Yes Yes Yes Yes Yes

               

Information To Financial Markets              

Reports on Monetary Policy S M Q M Q Q Q

Forecasts Released S S Q S Q Q Q

               

Operational Procedures              

Policy Meetings Per Year 8 12 12 14 8 8 11

Decisions Announced Immediately After Policy Meetings Yes Yes Yes Yes Yes Yes Yes

Press Releases Immediately After Policy Meetings Yes Yes Yes Yes Yes Yes Yes

Press Conferences (After Meetings) Yes** Yes Yes Yes No Yes No

Voting Results Published Yes No Yes Yes No No Yes

Full Minutes of Policy Meetings Published Yes No Yes Yes No No Yes

Weeks After Minutes Published 3   2 5     2

Note: *Implied Target for U.S.; **Fed will hold 4 a year, beginning in April 2011. M = Monthly; Q = Quarterly; S = Semi-annual.        

Links to World’s Major Central Banks United States:http://www.federalreserve.gov/

European Union: http://www.ecb.int/

Bank of England:http://www.bankofengland.co.uk/

Bank of Japan:http://www.boj.or.jp/en/index.htm

Other Useful Web Sites Links to all the world’s Central Banks (note:

172 banks as of March 27, 2011) http://www.bis.org/cbanks.htm

Federal Reserve statistical data http://www.federalreserve.gov/releases/

Economic time series, U.S. and some foreign (also allowing for graphing of data) http://www.economagic.com/

Appendix 1: The Channel of Fed Policy

The following is from the Federal Reserve web site and articulates in the Fed’s words the channel of monetary policy in the U.S. today

U.S. Monetary Policy Channel According to the Federal Reserve: “Using the three policy instruments, the Federal

Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and in this way alters the federal funds rate.

Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.” http://www.federalreserve.gov/monetarypolicy/fomc.htm

Appendix 2: The Organizational Structure of the Federal Reserve

Formal Structure of the Federal Reserve System

The system (i.e., formal structure) as it exists now includes: Twelve Federal Reserve Banks Member Banks, i.e., members of the Federal Reserve

(around 3,600, out of about 7,500 banks) Seven individuals who are members of the Board of

Governors (BOG) of the Federal Reserve System (including a Chairman).

Twelve individual members of the Federal Open Market Committee (FOMC).

Federal Advisory Council (12 bankers) Note: The system, however, is dominated by the Board of

Governors

Formal Structure of the Fed

The Twelve Federal Reserve Districts

The Federal Open Market Committee Undoubtedly the most closely watch group within the Federal

Reserve is the Federal Open Market Committee. There are 12 members on the FOMC:

All seven members of the Board of Governors plus the president of the Federal Reserve Bank of New York and four other presidents among the remaining 11 Federal Reserve District Banks (see Appendix 1 for the Fed structure).

The chairman of the Board of Governors is the chair of the FOMC.

The FOMC has scheduled meetings 8 times a year (about every 6 weeks); although emergency meetings can be called anytime, and at these meetings:

The FOMC makes decisions regarding the level of the federal funds rate.

Appendix 3: History of Other Major Central Banks

The Bank of England, the Bank of Japan and the European Central Bank are discussed in the slides that follow

Bank of England Founded in 1694 initially to manage the U.K.

Government’s accounts and to borrow on behalf of the Government (usually to finance wars with France).

Controlled by the Government until granted “interest rate” autonomy in 1997 by the Labor Party.

Since May 1997 the Bank’s 9 member Monetary Policy Committee has had statutory responsibility for setting interest rates to meet the Government's stated inflation target. Each year the Chancellor of the Exchequer sets an inflation

target for the country (currently 2%). The MPC has to judge what interest rate is necessary to meet

that inflation target. The Bank implements its interest rate decisions by setting the

interest rate at which the Bank lends to commercial banks and other financial institutions in the U.K.

European Central Bank (ECB) Founded in January 1999 by a treaty between the

European Central Bank (ECB) and the European System of Central Banks (ESCB). Stated goal is to maintain price stability in the euro area (at

inflation rates of below, but close to, 2% over the medium term). The 18 member Governing Council is the main decision

making body of the ECB. Consist of 6 Executive Board Members (chosen by the 12 euro

member governments) plus the 12 governors of all the national central banks from the 12 euro area countries

The Governing Council meets its inflation target by setting the interest rate at which banks borrow from the central bank (similar to U.S. federal funds rate). The key ECB rate is the interest rate on “refinancing operations”

which provide the bulk of liquidity to the banking system.

Bank of Japan (Nippon Ginko) Founded in 1882. The Bank of Japan Law (1998) gave the Bank of Japan

autonomy for monetary policy. Also stated that monetary control shall pursuit price stability.

The 7 member Policy Board targets an overnight interest rate for “uncollateralized call money” (similar to U.S. federal funds).

The Bank controls the call money rate on a daily basis through money market operations (similar to open market operations). Also uses an official discount rate at which it will make loans to

banks. At the present time, the Bank of Japan does not have a

specified inflation target.