14 – Central Banks

Cecchetti Chapter 15

Early History of the Fed

Federal Reserve Act: 1914 Created as a bureau of the Treasury and the

Secretary of Treasury was required to serve as an ex officio Chairman of the Federal Reserve Board.

Act signed by President Wilson

Central Banks

Primary reason central banks exist: print currency and control monetary policy Free markets cannot do this: adverse selection

Banker’s Bank Provide loans during times of financial stress Manage the payments system Regulate commercial banks

How does the Fed Work?

When the Fed wishes to increase the money supply (shift AD curve to right) Buys U.S. bonds from commercial banks

When the Fed wishes to decrease the money supply (shift AD curve to left) Sells U.S. bonds from commercial banks

Together these are called “open market operations”

Money Supply and Interest Rates

When the money supply increases, interest rates drop inflation pressure increases

When the money supply decreases, interest rates increase Inflation pressure decreases

Central Bank Objectives

Low stable inflation

High Stable Real Growth

Stability of the financial system

Interest Rate Stability

Effective Central Banks

Independence from political pressure Control over own budgets Policies must be irreversible

Decision making by committee Risk of putting one person in charge can be high

Accountability and Transparency Establish a system of goals Publicly report progress

Independent Central Banks

Aggregate Output, Y

PDo independent central banks just keep the money supply too low (line A)?

Do central banks run by political leadersdo a better job keeping the economyRunning at full capacity (line B)?

A

B

Independent Central Banks

Aggregate Output, Y

P

Empirical Evidence:

There is no difference in unemploymentrates across countries with independent central banks (line A) and withoutIndependent central banks (line B).

Countries without independent central banksJust have higher inflation.

A

B

Banking Act of 1935

Federal Reserve reorganized Board of Governors shall be composed of seven

members, appointed by President Among these is appointed a Chairman and Vice

Chairman

First Chairman: Mariner S. Eccles A principal sponsor of the act Was serving as an assistant to the Secretary of the

Treasury and a Governor of the Federal Reserve Board

Mariner S. EcclesFed Chairman 1936 – 1948Fed Governor 1948-1951

Federal Reserve Eccles Building

Eccles and Fed independence

1947: Inflation at 14% 1948: Inflation at 8% Treasury wanted to keep rates low

Facilitate war debt funding

Fed (Eccles) wanted to contain inflation Congress supported Eccles Truman declines to reappoint Eccles in 1948

Eccles and Fed Independence

Thomas McCabe Chairman 1948-1951 1951: Same argument between

Treasury and Fed emerged

Truman calls FOMC to Whitehouse Snyder, Secretary of Treasury,

announces that rates will be kept at 2.5%

Eccles and Fed Independence

Eccles releases confidential minutes of White House meeting to public

Asks Truman to resolve the conflict

Truman had William McChesney Martin, a Treasury Official, negotiate.

Eccles and Fed Independence

Martin made the Chair of the Fed in 1951.

Accord of 1951 was signed making clear that the Fed was independent of the Treasury.

Federal Reserve System

Central Government Agencies Board of Governors 12 regional banks FOMC

Private Banks

Advisory Committees

Federal Reserve Regional Banks

Board of Governors

Seven Governors Appointed by President Confirmed by Senate Serve 14 –year terms Terms staggered with a term beginning once every two

years

Chairman and Vice Chairman Appointed by president from among the seven Four year terms

No two governors can serve from the same district

Board of Governors Duties

Analyzes financial and economic conditions

Administers consumer credit protection laws Supervises and regulates the regional Reserve

Banks, including budgets and salaries Sets the reserve requirement Approves bank merger applications Regulates and supervises the banking system Collects and publishes data

Regional Banks

Federally charted banks and private, nonprofit organizations owned by commercial banks

Managed in part by Board of Directors Nine members Some chosen by private banks Others chosen by Board of Governors

Managed in part by a president Appointed for a five-year term by banks board of

directors with approval from Board of Governors

Regional Banks

As the bank for U.S. government Issue new currency and destroy old currency Maintain U.S treasury bank account/borrowings

As the banker’s bank Hold deposits (reserves) which pay zero interest Operate payments network (checks, debit cards, . . .) Make discount loans Supervise and regulate financial institutions Collect data

Federal Reserve Bank of New York

Point of contact with financial markets Open market operations Treasury securities are auctioned

Federal Open Market Committee

Has twelve voting members Seven governors President of FRB New York Four Reserve Bank Presidents

Serve one-year terms President of FRB Chicago and Cleveland vote

every other year Other nine presidents vote one out of every three

years

Federal Funds Rate

Federal Funds Rate Rate at which banks borrow from each

other overnight Determined by supply and demand When there are excess reserves, FF rate

is low When there is low supply of reserves, FF

rate is high

Discount Rate

Rate at which banks can borrow money from Fed at discount window.

Set by regional banks’ boards of directors Set automatically at a premium above the

Federal Funds rate.

FOMC

Targets Federal Funds Rate If prices are “sticky” than they influence

the “real rate”

Real = Nominal – Inflation

Policy decision directs staff at FRB

New York to engage in open market operations

Federal Open Market Committee

Beige Book Published two weeks before meeting Anecdotal information about economic conditions Only document released to public before meeting

Green Book Distributed Thursday before meeting Board Staff’s economic forecast for next few years

Blue Book Distributed Saturday before meeting Discussion of current markets and policy options

Power Within the FOMC Governors make up a majority

Green and Blue books prepared by Fed staff

Before formal vote, chair makes recommendation followed by others saying “yes” or “no” All bank presidents participate

Chair votes first

Board controls Regional Bank budgets and salaries

To impact policy, governors and bank presidents must generate support through statements in meeting and in public.

Assessment of Fed Structure

Independence Control own budget Decisions can’t be over-turned Terms are long Structure can only be changed by

congressional legislation

Decision by committee

Assessment of Fed Structure

Accountability and transparency Load of information on web sites Immediately after meeting: announcement of policy decision

and explanatory statement Minutes published about two weeks later After 5-years: word-for-word transcript, Blue and Green Books Twice yearly “Monetary Report to Congress” (see next slide)

Is it the right information? No press conference Blackout period 5-year delay for transcript, Green and Blue Books Inflation Targets?

Press Release 11/14/2007

The Federal Open Market Committee (FOMC) announced on Wednesday that, as part of its ongoing commitment to improve the accountability and public understanding of monetary policy making, it will increase the frequency and expand the content of the economic projections that are made by Federal Reserve Board members and Reserve Bank presidents and released to the public.

Press Release 11/14/2007

The FOMC will compile and release projections four times each

year rather than twice a year. The projection horizon will be extended to three

years, from two. FOMC meeting participants will now provide

projections for inflation real gross domestic product growth, the unemployment rate core inflation.