Central Banking and the Conduct of Monetary Policy

1. Central Banking and the Conduct of Monetary Policy Impact of Central Bank Actions on Financial Markets Central Banking Chapter 4 Part 2

2. 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? Because this will help us to predict future moves in (1) and (2) above.

3. Definitions of a Central Bank Text book definition: “The government agency that overseas the banking system and is responsible for the amount of money and credit supplied in the economy.” Other definitions: “The entity responsible for the monetary policy of its country” “The major regulatory bank in a country.” “The government agency whose responsibilities include: the issuance of currency, the administration of monetary policy, (e.g., open market operations, the discount rate), and engaging in transactions designed to facilitate healthy business interactions. (i.e., a sound financial system).”

4. Who Runs the Central Bank? In most countries (especially in the developing world) the central bank is state owned and has a minimal degree of autonomy. Which allows for the possibility of government intervening in monetary policy. However, central banks in the major countries of the world are “independent” of their governments. Which is designed to prevent political interference.

5. Major Central Banks Independence Central BankDate of Independence* Federal Reserve: 1913 Bank of England: 1997 Bank of Japan: 1998 European Central Bank: 1999** *Recognized date of separation from government influence. **ECB independence granted in original charter.

6. U.S. Central Bank: The Fed The United States lacked a central bank until the early twentieth century. There were two failed attempts to establish a central bank, the first in 1791 and the second in1816. As a result, there were frequent economic depressions and financial panics in the US 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. Act also called the Glass-Owen Act. The 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.”

7. Amended Goals of the Fed (Dec 2000) The Federal Reserve “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. Note: There are no specified inflation targets for the Federal Reserve. Question: Should there be one? See web site reading (“Should the Federal Reserve Target Inflation?)

8. 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

9. Formal Structure of the Fed

10. The Twelve Federal Reserve Districts

11. Federal Reserves Operating Tools How does the Federal Reserve (or any central bank) achieve its economic goals? Open market operations--purchases and sales of U.S. Treasury and federal agency securities--are the Federal Reserve's principal tool for implementing monetary policy. The Federal Reserve's objective for open market operations has varied over the years. During the 1980s, the focus gradually shifted toward attaining a specified level of the federal funds rate, a process that was largely complete by the end of the decade. In 1995 the Fed began to explicitly state its target level for the federal funds rate.

12. Federal Reserves Operating Tools The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility--the discount window. The Federal Reserve Banks offer three discount window programs to depository institutions: (1) primary credit (i.e., overnight), (2) secondary credit (to meet severe short term financial difficulties, and (3) seasonal credit, (to smaller institutions in agricultural or seasonal resort areas) Each discount program has its own interest rate and all loans must be fully secured (usually with Treasury obligations). The term discount rate is normally applied to primary credit loans.

13. Federal Reserves Operating Tools Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Reservable liabilities consist of transaction accounts, time deposits, and eurocurrency liabilities Since December 27, 1990, time deposits and eurocurrency liabilities have had a reserve requirement of zero. The reserve requirement on transaction accounts varies from 3% to 10% (depending upon the amount). Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks.

14. What “Operational” Variable Should a Central Bank Target? • One of the issues which any central bank faces is what “operational” target should they use when adjusting monetary policy tools. • From a practical standpoint, the choice is between: • A monetary aggregate such as the money supply or bank reserves, or • A financial market variable such as an interest rate or an exchange rate

15. Complete Target Timeline • Monetary Policy Tool • Open market operations • Operational Target • Monetary aggregates • Financial market variables • Macroeconomic Target • Inflation • Economic growth

16. Historical Use of Operational Targets by the Federal Reserve • In the years immediately after WW II, the Fed agreed to peg interest rates at very low levels (3/8% on Treasury bills and 2 ½% on Treasury bonds) to hold down the Treasury’s war financing costs. • In 1951, an agreement (“The Accord”) was reached between the Treasury and the Fed whereby the Fed would no longer peg interest rates. • In the 1950 and 1960s, the Federal Reserve shifted its target to money market conditions, and specifically short term interest rates. • By the 1970s, under increasing criticism from monetarists that central banks were unable control inflationary pressures, the shift was to the intermediate targeting of monetary aggregates, specifically various money supply measures (M1, M2, etc). • However, the shorter term target used to achieve a specified monetary target was still the interest rate (and specifically the fed funds rate in the US).

17. Recent Record of Central Bank Operational Targeting • In the 1970s, most major central banks had adopted some form of monetary aggregate targeting. • Bank of England in 1973 • Bundesbank in 1975 • Bank of Japan in 1978 • However, by the late 1970s/early 1980s, central bank concerned about the wide swings in interest rates, combined with their apparent inability to meet their monetary aggregate targets, began to deemphasize this monetary aggregate approach. • There was also growing research suggesting that the “predictable” relationship between money supply aggregates and economic growth had broken down. • The monetary policy target shift, therefore, was to eventually focus back on an interest rate target.

18. Current Central Bank Operational Targeting • In recent years, central banks have abandoned their monetary aggregates (e.g., in July 1993 the Fed announced that they would no longer use monetary targets). • By the early 1990s, they were all using some short term interest rate as their operational target. • 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

19. Board of Governors and the FMOC The seven governors are appointed by the President, and confirmed by the Senate, for 14-year terms on a rotating schedule. All are members of the Federal Open Market Committee (FMOC): There are 12 members on the FOMC (7 are from the Board of Governors) The chairman of the Board of Governors is also the chair of the FOMC. The FOMC meets 8 times a year (about every 6 weeks), and: Makes a decision regarding the level of the federal funds rate.

20. Policy Statements from the FOMC At the conclusion of each FOMC meeting, the FOMC will issue a public statement which highlights the meeting. This statement will begin by stating what, if anything, the FOMC has decided to do with the federal funds rate. This statement also reviews the current economic environment. This statement also provides opinions as to where the FOMC sees the economy moving in the near term as well as noting any potential problem area (e.g., inflation, or specific sectors). The statement will end with a review (breakdown) of the votes. As such, readers look for “clues” as the future outlook for monetary policy. Will policy tighten, eased up, or stayed the course? After three weeks, the FOMC will release the full minutes of its meeting. For a calendar of future meetings and past statements and full minutes see: http://www.federalreserve.gov/fomc/#calendars

21. Summary of September 18, 2007 Meeting • The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 4-3/4 percent. • Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally.  Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.  • Readings on core inflation have improved modestly this year.  However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.  • Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook.  The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth. • In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 5-1/4 percent.  • Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; Eric Rosengren; and Kevin M. Warsh.  

22. Importance of the Federal Funds Rate The federal funds rate is the interest rate at which depository institutions lend reserve balances through the Federal Reserve system to other depository institutions These reserve loans are essentially on an overnight basis. Why is the federal funds rate important? Because changes in the federal funds rate trigger a chain of events that affect: The amount of money and credit in the economy (via lending activities) Other short-term (money market) interest rates, Long-term interest rates, Foreign exchange rates, and, Ultimately, a range of economic variables, including employment, output, and prices of goods and services.

23. Federal Funds Rate: 1970 - Present

24. Impact of Fed Funds Rate on Business Loan Interest Rates (Prime Rate)

25. Impact of Fed Funds Rate on Money Market Interest Rate (CD Rate)

26. Impact of Fed Funds Rate on Long Term Corporate Bond Rate (Aaa Rate)

27. Impact of Fed Funds Rate on Mortgage Lending Rate (30-Year Rate)

28. Impact of Federal Funds Rate on Dollar

29. Central Bank Operational Target Interest Rates, October 22, 2007 • Federal Reserve: • Federal Funds Rate: 4.75% • Bank of England: • Official bank rate: 5.75% • European Central Bank: • Main refinancing rate: 4.00% • Bank of Japan: • Uncollateralized overnight call rate: 0.5%

30. Appropriate Macroeconomic Target • Monetary Policy Tool • Open market operations • Operational Target • Monetary aggregates • Financial market variables • Macroeconomic Target • Inflation • Economic growth • Exchange rates

31. Historically Use of Macroeconomic Targets • From a practical standpoint there are any number of macroeconomic variable a central bank might target. These include: • A unemployment rate • A real GDP growth rate • An exchange rate • 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. • However, beginning with the Central Bank of New Zealand in March 1990, central banks have been adopting either explicit or implicit inflation rates for their macroeconomic target.

32. Adoption of Inflation Targets • Some central banks have adopted explicit inflation targets: • New Zealand: March 1990 (set at 0% to 2%) • Canada: February 1991 (set at 2% to 4%) • United Kingdom: October 1992 (set at 1% to 4%) • Australia: 1993 (set a 2% to 3%) • Euro-zone: January 1999 (set below, but close to, 2%) • Brazil: June 1999 (set at 8%) • South Africa: 2002 (set a 3% to 6%) • Other central banks have implicit inflation targets: • Japan: “The Bank of Japan's mission is to pursue price stability, in other words to maintain an economic environment in which there is neither inflation nor deflation.” • United States: “shall maintain long run growth of the monetary and credit aggregates … so as to promote … stable prices …”

33. Inflation Targeting Statements “The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.” “The Bank of England’s monetary policy objective is to deliver price stability…defined by the Government’s inflation target of 2%.” “Bank of Korea has adopted inflation targeting and its current inflation target has been set for the period 2004-2006 as a range of 2.5-3.5%.” “The Central Bank of Iceland's main objective is price stability, defined as a 12-month rise in the CPI (Consumer Price Index) of 2½%.” “The Bank of Switzerland’s monetary policy aims at ensuring price stability in the medium and long term; price stability is defined as a rise in the national consumer price index (CPI) of less than 2% per annum.

34. Should Central Banks be Independent? Traditionally, most central banks were “agents” of their respective governments. In recent years, however, there has been growing debate as to the wisdom of this arrangement. Case for Central Bank Independence: Independent Central Bank is likely to have longer run objectives while politicians may have shorter term objectives. Empirical work suggests that countries with the most independent central banks do the best job of controlling inflation and achieving economic growth (see next slides). Independence also avoids a “political” business cycle. Case against Central Bank Independence Central Bank may not be accountable Hinders coordination of monetary and fiscal policy

35. Central Bank Independence and Inflation, 1973-1988

36. Central Bank Independence and Economic Growth, 1973-1988

37. Central Bank Transparency Transparency means that a central bank provides the general public and the markets with all relevant information in an open, clear and timely manner. Today, most central banks consider transparency as crucial to their success. Many Central Bank web sites now in English. Many central bankers regularly talk to the “public.” Central Bank decisions and actions are published in a timely and open manner. 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 meets monthly and announce their interest rate decisions immediately following the meeting. http://www.boj.or.jp/en/theme/seisaku/kettei/index.htm

38. Links to World’s Major Central Banks United States: Ben Bernanke http://www.federalreserve.gov/ European Union: Jean-Claude Trichet http://www.ecb.int/ Bank of England: Mervyn King http://www.bankofengland.co.uk/ Bank of Japan: Toshihiko Fukui http://www.boj.or.jp/en/index.htm

39. Other Useful Web Sites Links to all the world’s Central Banks 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/

40. Other Major Central Banks The Bank of England, the Bank of Japan and the European Central Bank are discussed in the slides that follow

41. 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.

42. 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.

43. 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.