In the next three chapters, we look at central banking and monetary policy, to understand the important effect that central banks have on the economy.  Central banks regulate the supply of money, which affects what?

1.

2.

3.

4.

5.
 

We look at the structure of central banks and focus on the Federal Reserve Bank (FRB) in the U.S., the largest and most important central bank in the world.  The reason that "money" and "banking" go together is because of a) the connection between central banking and money, money supply, monetary policy, and b) the connection between central banking and commercial banking.   To implement monetary policy the central bank relies on commercial banks, because monetary policy really works by affecting the amount of bank reserves in the economy.   Fed sets monetary policy, but it uses the banking system to implement the policy, which then affects the financial markets - Money, Banking and Financial Markets.
 

ORIGINS OF THE FRB

Our banking industry is unique in the world, and so is our central bank, reflecting the long history hostility of the public toward large banks and the fear of centralized power of any kind, including centralized banking power.  Remember that the first two attempts at central banking failed in the 18th and 19th centuries (First and Second Banks of the United States).  Also, the most important central bank in the world at that time (and the model for central banking) was the Bank of England (chartered in 1694), so there was probably resistance to copying the British model of centralized, concentrated banking authority, given U.S.-British history.  There was concern that a single central bank would concentrate power in Washington, D.C., and that large corporations and powerful, rich families on the East coast would have too much control over banking, at the expense of farmers, small businesses, middle-class people in the south, west, midwest, etc.

However, bank panics, bank failures and bank runs were also happening on a regular basis, and this was causing concern, especially the bank panic of 1907, which caused substantial losses to thousands of depositors.  The concern over a fragile banking system with frequent panics finally outweighed the concern about centralized banking power, and the establishment of the FRB in 1913 followed eight years of debate and compromise.  Public support was generated for a central U.S. bank because of two unique features of our central banking system, which helped overcome the resistance to centralized federal banking power.

1. Federal Reserve System (FRS) is a decentralized system of district, regional banks that represented the population distribution of the early 1900s.  This regional district-based system appealed to U.S. populist sentiments, and local and regional concerns, as an alternative to establishing a central bank located in Washington D.C. or NY, which was not politically feasible.  See map page 371.  FRS has 12 district banks in major cities - Chicago, Cleveland, Atlanta, NY, SF, Mpls, etc. - and 25 regional branch banks in other large cities, like Detroit.  Each district bank has a president, usually a commercial banker from the private banking sector.

2. FRS is "quasi private" institution, part private corporation, part public institution, which is unlike any other governmental agency or bureau.  Being quasi private gave assurance to public that being part private would increase accountability in general, and would guarantee that local concerns were considered.  The private commercial banks in a district who are members of the FRS (all national banks and some state banks) own the stock of the district bank (requirement of membership).  For example, Bank One and Citizens Bank own stock in the Chicago district Fed Reserve Bank, get paid dividends of 6% per year.  (Note: In other countries, the central bank is owned the federal government)

Also, each district Federal Reserve Bank (FRB) has a board of directors (9 members), like a private corporation.  The private commercial banks in a district elect 6 (A and B class) of the 9 directors and the Board of Governors of FRS elects 3 (class C), giving the private banks a super majority over the Governors, who are appointed by the President and confirmed by the Senate.  

Class A - 3 professional bankers from the district
Class B - 3 leaders in the district from industry, labor, agriculture or consumer sector
Class C - 3 non-bank directors, representing the public interest, who have no tie to the banking industry.

The structure of the district FRB's board of directors is designed so that all constituencies are represented.  The board of directors in a district elects the president of the district FRB, subject to approval by the Board of Governors.

FUNCTIONS OF FRS District Banks:
1. Clear checks
2. Issue new currency
3. Withdraw worn currency
4. Evaluate proposed mergers and applications for banks to expand activities.
5. Make discount loans to banks
6. Examine bank holding companies and state chartered member banks.
7. Collect data on local business conditions
8. Conduct research on monetary issues
9. Provide public service information on consumer issues like credit cards, auto leasing, consumer credit reports, etc.
 

FORMAL STRUCTURE OF FRS (See page 370):

BOARD OF GOVERNORS - decision making head of the FRS with 7 members.  Fed Governors are appointed by the President, subject to confirmation by the US Senate, with non-renewable 14 years terms.  Terms are staggered, and one governor term expires every other January 1, so that the president can only appoint two governors each term.  Governors are supposed to come from different districts around the country to guarantee that regional concerns are heard.  Board of Governors sets reserve requirements and sets the discount rate (currently ____%), two of the tools of monetary policy.

CHAIRMAN OF FRS: One of the governors is appointed chair by the President, for a four year renewable term.  Greenspan is in his 4th full term, was appointed in 1987 by Reagan, and has served under four presidents.  Greenspan's current term expires in June 2004.

Federal Open Market Committee (FOMC) - the actual decision making body that sets monetary policy.  FOMC meets 8 times a year, about every six weeks (2002: Jan 29/30, Mar 19, May 7, June 25/26, Aug 13, Sept. 24, Nov. 6, Dec 10).  FOMC has 12 members including the Board of Governors (7) and 5 of the 12 FRS presidents - the president of the N.Y. FRB always gets a seat on the FOMC, and 4 other FRB presidents of the remaining 11 banks (2001: Boston, Chicago, St. Louis and Kansas City).  The other bank presidents can attend the meetings and make comments, but only FOMC members can vote on policy.  The first part of FOMC meetings involve a general discussion of local and national economic conditions, and each bank president gives an overview of economic conditions in their district, and each governor comments on their views of the economy.  The FRB's research staff also participates, and Director of Research presents an economic forecast for the U.S. economy.  Topics discussed include: industrial production, interest rates, consumer spending, trade deficit, inflation, ex-rates, unemployment, etc.

Later in the day, the chairman gives his/her views and finally recommends a course of monetary policy in the form of a proposed directive (raise interest rates, lower interest rates, leave interest rates unchanged, etc.), and the FOMC votes on the proposal.  The Board of Governors has a slight majority (7/5) over the bank presidents.  Decisions are usually, but not always, unanimous.  The monetary policy decision usually involves implementing an "open market operation" (OMO), which are the most important tool that the Fed has for controlling the MS.   Since the most important policy decisions are made about monetary policy at these meetings, the FOMC is the focal point for Fed policymaking.  Note: FOMC doesn't conduct the actual OMO, but directs the NY FRB to either buy or sell Treasury securities.

Special role of NY Fed. See page 372.
1. N.Y. FRB president is permanent member of FOMC as vice-chairman.
2. OMOs are carried out at the N.Y. FRB because of the close proximity to financial markets (NYSE, etc.).
3. Foreign exchange trading by FRB takes place at N.Y. FRB.
4. N.Y. FRB president is a permanent member of the Bank for International Settlement.
 

THREE TOOLS FOR MONETARY POLICY:

1. Reserve requirements (RR) - minimum amount that banks have to hold as reserves, as a percentage of deposits.  Reserves for a bank are: vault cash + deposits on account at the FRS (most banks have an account at the district FRB).  Current reserve requirements: no reserves are required for time deposits and savings accounts.

Reserves on checkable deposits are 3% for the first $52m and then 10% for amounts over $52m.  The worldwide trend has been toward lower reserve requirements - Canada, Switzerland, N.Z. and Australia have eliminated RR entirely.  Why?

If the FRS lowers reserve requirements, this is ____________ monetary policy.  The smaller the amount of required reserves, the more funds are available to loan out and expand the money supply.   Raising the reserve requirements would be ________________ monetary policy, it would contract/reduce the MS.

2. Discount Rate - rate that FRS charges banks to borrow reserves.  Currently at ________.  Alternatively, banks can borrow at the fed funds rate (FFR) in the Federal Funds market, currently around ______.  See page 443 for a graph of the FFR vs. Discount Rate.

If the Fed lowers the discount rate, it would be expansionary because it would be less costly to borrow reserves.  If the Fed raises the discount rate, it would be contractionary because it would be more expensive to borrow from the Fed.  Banks would more willing to hold excess reserves to avoid high borrowing costs.

3. Open Market Operations (OMO)-  Buying and selling Treasury securities to increase or decrease the MS.  When the Fed buys a Tbill in an OMO, it puts new money into the banking system and increases the MS.  You give the FRS a Tbill and they issue you a check on funds that didn't exist before, the "magic checkbook."  

When the Fed sells a Tbill, the FRS gives you a Tbill, you give them a check.  When the check clears, the reserves of the banking system are reduced, and the MS decreases or contracts.

Buying Tbills, lowering RR and lowering the discount rate are EXPANSIONARY.
Selling Tbills, raising RR and raising the discount rate are CONTRACTIONARY.

On net, the MS is increasing over time (see graph p. 10), so the Fed is typically implementing expansionary monetary policy.
 

IMPORTANT ISSUE: INDEPENDENCE OF THE CENTRAL BANK

FRB/Central Bank is supposed to have some degree of independence, meaning that it can carry out monetary policy independently from the influence of Congress or the President (elected officials), or Parliament/Prime Minister.  To be most effective, central banks should be free from political influence.   Why???

The more independent the central bank, the greater chance of monetary stability (low and stable inflation).  The most independent banks are in the world are Germany (Bundesbank) and Switzerland, followed by U.S., Japan, Netherlands, and Canada, and these countries have had the lowest and most stable inflation rates, see page 388.  German central bank has been considered the most independent bank in the world and is not required to report to Parliament of any other government agency.  Also, the formally stated mission of the German central bank in its charter is to achieve PRICE LEVEL STABILITY.   The newly created European Central Bank will be even more independent than the Bundesbank, because it will operate completely independently of both the European Union and the national governments of the 11 euro countries.  Also, its charter cannot be changed by legislation, it can only be changed by a revision of the Maastricht Treaty, requiring a unanimous vote of all nations. 

INDEPENDENCE OF U.S. FRB:

1. Governors are appointed to one, non-renewable term for 14 years.  Because terms are not renewable, Governors aren't obligated to appeal to the wishes and pressures of politicians.  Because the terms are 14 years, they have a longer time frame than most elected politicians, and cannot be removed from office for political reasons.

2. FRB does not get money from the government like other governmental agencies, and the FRB actually makes large profits ($20B) from its portfolio of $500B worth of Treasury securities (see page 392), fees for its check clearing services, and loans to banks.  Therefore, the FRB is totally self-sufficient financially and NOT subject to the appropriations process controlled by Congress.  Being independent from government funding gives the FRB autonomy and independence.

However, FRB is a creation of Congressional legislation, so Congress ultimately controls the charter of the FRS, and they occasionally threaten the FRB with more Congressional control.  For example, Congress has enacted several legislations that require the FRB to be more accountable:

FRS chairman is required by law to:
1. Publicly announce its objectives quarterly for growth rates of the monetary aggregates (M1, M2 and M3) over the next 12 months. (Resolution 133 passed in 1975)

2. Report to Congress twice a year (Humphrey-Hawkins Act of 1978) to explain how monetary policy is consistent with economic plans of the President and how monetary policy will achieve full output.
 

CASE FOR INDEPENDENCE OF CENTRAL BANK

Empirical record, page 388, shows independence (political insulation) and monetary stability (low and stable inflation) are closely related.  Without independence, there is a strong inflationary bias, due to political pressure.  Why???

Political Business Cycle Theory (PBC).  Shortsightedness of politicians creates an inflationary bias before elections.  Because of political influence, the central bank engages in expansionary monetary policy before national elections, which temporarily stimulates the economy with the positive effects of lower interest rates, higher output and employment, helping incumbents get re-elected or retaining power for their party.

After the election, inflation and unemployment start to rise, causing a subsequent recession between elections, leading to a business cycle caused by political influence over monetary policy, a Political Business Cycle (PBC).   The average U.S. recession lasts about a year, so that there is enough time for the economy to go into a recession after the election, and enough time to later re-stimulate the economy with a subsequent monetary expansion before the next election (assuming a four year presidential election cycle).

Evidence: An international study of 90 elections in 27 countries found that national income (GDP) increased in 77% of election years vs. only 46% of the non-election years, revealing some international evidence that expansionary monetary policy is used to influence the outcome of the political elections (PBC).

U.S. Evidence:

Presidential Election  -                    Recession
1952 Eisenhower                                1954
1956 Eisenhower re-elected                 1958
1960 Kennedy                                    1960 (end of year, after election)
1964 Johnson
1968 Nixon                                        1970
1972 Nixon re-elected                         1974-75
1976 Carter
1980 Carter loses                                Jan 1980-July 1980 and July 81-Nov 82
1984 Reagan re-elected
1988 Bush                                          July 90- March 91 (Bush lost, economy recovered right after election)
1992 Clinton
1996 Clinton

Independence will increase the long run focus of the central bank, and insulate the central bank from being influenced by the short run goals of politicians.  Independent Fed can pursue policies that are politically unpopular but in the public interest, like the contractionary monetary policy of the early 1980s that caused two recessions.  

Example: Paul Volcker was appointed in 1979 by Carter and was committed to decreasing inflation.  Volcker pursued tight, contractionary, restrictive monetary policy and  interest rates rose, causing an inverted yield curve and a recession followed.  This policy was politically unpopular (may have cost Carter the election), but was in the interest of the economy in the LR, resulted later in lower inflation, lower interest rates.  
 

CASE AGAINST INDEPENDENCE

Potential abuse of power by central bank, if there is a lack of accountability. Independent central bank could be considered undemocratic.  And the FRB has not always pursued appropriate monetary policy, e.g. deflationary 1930s and the inflationary 1970s.

Nobel economist Milton Friedman in his presidential address to the American Economic Association in 1967: "Every major contraction in this country has been either produced by monetary disorder or greatly exacerbated by monetary disorder. Every major inflation has been produced by monetary disorder."

Independence is good if the chairman provides effective leadership (Greenspan), bad if the chairman is not an effective leader.  Reason why chair only gets a 4 year term, to make is easy to remove an ineffective chair.  

The narrower the focus of monetary and the clearer the objectives, the less potential for abuse by central bank when independent. Examples: Germany's Bundesbank has been the world's most independent central bank, and has also been the most successful at achieving the stated goals of monetary stability and low inflation, partly because its charter explicitly directs them to achieve price level stability as its primary stated goal.

New alternative in monetary policy: INFLATION TARGETING, in New Zealand, Canada and U.K., (see page 523), has been successful at lowering and stabilizing inflation.  Central bank is directed to meet some transparent, publicly announced inflation target, e.g. a target range like 0-3% in N.Z., 1-3% in Canada, or a point target of 2.5% in U.K.