International Financial Economics
The European Central Bank (ECB) and
the Federal Reserve (the Fed):
differences and similarities in setup,
operational procedure, and monetary
policy
Akmal Rahimov
Hari Widodo
Yudha Hadiyanto
1
OUTLINE:
• PART I : General Overview, Historical
Background, Organizational Structure,
Main Functions and Tasks of the Federal
Reserve and ECB
• PART II : Differences and similarities in
Operational Procedures of Federal
Reserve and European Central Bank
• PART III : Monetary Policy
2
PART I:
General Overview, Historical Background,
Organizational Structure, Main Functions and
Tasks of the Federal Reserve Bank
and European Central Bank (ECB)
3
The Role of Central Bank



Issuer of the currency
Controller of the
money supply
Lender of the Last
Resort
4
Why the US need a central bank?
1. The United States lacked a central bank until
the twentieth century
2. Needs a money manager, to handle the nation's
financial system.
3. Financial panics, the Bank Panic of 1907
convinced the public that a central bank was
necessary.
5
Why the US need a central
bank?(Continued)
4. To reform the financial system to be more
integrated and secure in supporting the
developing economy.
5. In 1913, after considerable debate, Congress
passed the Federal Reserve Act to balance the
financial needs of the country.
6
Why European System of Central Bank
(ESCB) is needed?
1. Primary objective : to maintain price stability, as
defined in Article 2 of the Statute of the ESCB
and of the ECB.
2. Price stability : a year-on-year increase in the
Harmonized Index of Consumer Prices (HICP) for
the euro area of below 2%. To be maintained over
the medium term.
3. The Governing Council announced that, in the
pursuit of price stability, it would aim to maintain
inflation rates close to 2% over the medium term.
7
Historical Background
FEDERAL RESERVE




Drafted by Congress as the
Federal Reserve Act in 1913
EUROPEAN CENTRAL BANK

Established on 1 June 1998, as
one of the world’s youngest
central banks.
The act began in 1908, when
Congress set up the National
Monetary Commission to
pinpoint weaknesses in the
nation’s financial system.
Triggering Factors : Monetary
panic
(Bank commitment)
The commission found that
the United States lacked a
reliable method to provide
liquidity to the money supply.


Triggering factors : the presence
of EMU (political decision), i.e.
to maintain price stability
EMU:
o Stage 1: Restriction on the
movement of capital were
abolished (1990)
o Stage 2:Establishment of
EMI and ECB
o Stage 3:Irrevocable fixing of
exchange rate
8
Historical Background(Continued)
►
President Woodrow Wilson
signed the Federal Reserve
Act into law on Dec. 23,
1913, to help to maintain
a stable, healthy and
growing economy.
◊ The legal basis : the Treaty
on European Union signed on
February 7, 1992 in Maastricht
which established the European
Community.
◊The ESCB is composed of the
ECB and the national central
banks of all 15 EU Member
States.
9
Stages to Monetary Union
1.
Maastricht Treaty
2. Establishment of the EMU
3. Irrevocable fixing of exchange rates
10
Inseparable Story: EMU and the ECB
Stage 1: Maastricht Treaty
1. 1 July 1990, the first stage : movement of capital
among the European Economic Community (EEC)
countries should be demolished. the committee of
governors decided to facilitate the preparatory work
for the establishment of EMU (the Treaty of Rome)
2. 1991 intergovernmental conference agreed to revise
the Treaty of Rome in order to establish the required
institutional structure. Represented on the Treaty on
European Union, signed in Maastricht on February 7,
1992.
11
Stage 2 : Establishment of the EMU
1.
1 January 1994 : The establishment of the European Monetary
Institute (EMI)The EMI had no responsibility for the conduct of
monetary policy in the European Union
2.
December 1995 : the European Council agreed to name the
European currency unit to be introduced the "euro", and
confirmed that Stage Three of EMU would start on 1 January 1999.
3.
December 1996 EMI also presented to the European Council, and
subsequently to the public, the selected design series for the euro
banknotes to be put into circulation on 1 January 2002.
12
4. 25 May 1998 : the governments of the 11
participating Member States (Belgium,
Germany, Spain, France, Ireland, Italy,
Luxembourg, the Netherlands, Austria,
Portugal and Finland) appointed the
President, the Vice-President and the four other
members of the Executive Board of the ECB.
•
With the establishment of the ECB on 1 June
1998, the EMI had completed its tasks. The
EMI went into liquidation on the establishment
of the ECB.
13
Stage 3: Irrevocable fixing of
exchange rates


1 January 1999 : the irrevocable fixing of the
exchange rates of the currencies of the 11
Member States initially participating in
Monetary Union was commenced along with
the conduct of a single monetary policy under
the responsibility of the ECB.
1 January 2001 : Greece joined the EMU,
making the number of participating Member
States increased to 12.
14
Basic Tasks of Federal Reserve and European Central
Bank

Federal Reserve
manages supply of money
and credit

keeps the wheels of
business rolling



serves as the banker for
the federal government by
providing financial
services for the U.S.
Department of the
Treasury
supervises and regulates a
large share of the nation's
banking and financial
system;
administers banking and
finance-related consumer
protection laws.





European Central Bank
To define and implement
monetary policy in Euro
area
To maintain price stability
and conduct foreign
exchange operations
Holding and manage the
official foreign reserves of
the Member States
Promote the smooth
operation of payment
systems
Provide prudential
supervision of credit
institutions and the
stability of the financial
system
15
Independence of the Central Bank
The ECB:
Based on the Maastricht
Treaty, neither ECB nor NCB
nor any member of decisionmaking bodies are allowed to
seek or to take instructions
from community institution or
bodies form any government
of any member states or from
any other bodies
The Fed:
Three structural features
give the Fed independence
in its conduct of monetary
policy:
- The appointment
procedure for Governor,
- The appointment
procedure for Reserve
Bank Presidents
- Funding.
However, it is ultimately
countable to Congress and
come under government
audit and review
16
Structure of the System of Federal
Reserve
Board of Governors of the Federal Reserve
Federal Open
Market Committee
Federal Reserve Banks
in
12 Districts
Member banks
Advisory Committees
17
Board of Governor of The Fed
1. Seven-member Board of Governors.
2. Appointed by the President of the United States and confirmed by the
Senate
3. Serve 14-year terms, arranged so that one expires in every evennumbered year. designed to be long enough to prevent day-to-day
political pressures
4. The President of the United States designates a Chairman and Vice
Chairman from the Board to serve four-year terms.
18
Federal District Bank (12)

District Banks. There are 12 Federal
Reserve Districts, or regions, throughout
the United States. Regional headquarters
are located in Boston, New York,
Philadelphia, Cleveland, Richmond,
Atlanta, Chicago, St. Louis, Minneapolis,
Kansas City, Dallas, and San Francisco.
Additionally, there are Branches of
Reserve Banks in 25 other cities.
19
Federal Reserve Districts and Branches
1.
2.
3.
4.
5.
6.
Boston
New York
Philadelphia
Cleveland
Richmond
Atlanta
7. Chicago
8. Saint Louis
9. Minneapolis
10.Kansas City
11.Dallas
12.San Francisco
20
Federal Open Market Committee
1. The Federal Open Market Committee (FOMC) consists of
twelve members
• The seven members of the Board of Governors of the
Federal Reserve System
• The president of the Federal Reserve Bank of New
York;
• Four of the remaining eleven Reserve Bank
presidents, who serve one-year terms on a rotating
basis.
2. Nonvoting Reserve Bank presidents attend the meetings
of the Committee, participate in the discussions, and
contribute to the Committee's assessment of the
economy and policy options.
21
Federal Open Market Committee
The FOMC has the primary responsibility for
conducting monetary policy.
Director of each Reserve Bank contributes to
monetary policy by making recommendations
about the appropriate discount rate
22
Member Banks
National banks chartered by the federal government
are, by law, members of the Federal Reserve System.
State-chartered banks may choose to become
members of the Federal Reserve System if they meet
the standards set by the Board of Governors.
23
Advisory Committee
The Federal Reserve System uses advisory and working
committees to advise the Board of Governors directly:
• Federal Advisory Council.
Consists of one member—traditionally a commercial
banker—from each Federal Reserve District.
Required by law to meet four times each year with the
Board of Governors to discuss economic and banking
matters.
• Consumer Advisory Council.
This statutory council has thirty members, meets with the
Board three times a year on matters concerning consumers
and the consumer credit protection laws administered by
the Board. Consists of academics, legal specialists in
consumer matters, and members representing the interests
of consumers and the financial industry.
24
• Thrift Institutions Advisory Council.
Board of Governors established this council to obtain
information and opinions on the needs and problems
of thrift institutions. The council is made up of representatives
of savings and loan associations, savings banks, and credit
unions.
25
Flow of Command in the FED
26
Source : ECB Brochure
27
Executive Board
1. The Executive Board comprises the President, the
Vice-President and four other members.
2. The main responsibilities of the Executive Board are:
• To implement monetary policy and, in doing so,
to give the necessary instructions to the NCBs;
• To execute those powers which have been
delegated to it by the Governing Council of the
ECB.
28
Governing and General Council
1. The Governing Council is the supreme decisionmaking body of the ECB which comprises the
members of the Executive Board of the ECB and the
governors of the national central banks which have
adopted the euro.
2. Only members of the Governing Council present in
person shall have the right to vote.
3. General Council is one of the three decision-making
bodies of the ECB. It comprises the President and the
Vice-President of the ECB and the governors of all 15
EU national central banks.
29
PART II:
Differences and similarities in
Operational Procedures of Federal
Reserve and European Central
Bank
30
Operational Procedure
Operational Procedure is the set of instruments and
procedures which a central bank uses to steer interest
rate, signal monetary policy intentions, and manage
liquidity in the money market.
Operational Procedures related to the monetary policy
and the instruments used such as open market
Operation, standing facilities, and reserve requirement.
31
Monetary Policy Framework
ECB:
• Primary objective of ECB is
maintaining the price
stability.
The Fed:
• controlling inflation and
promote economic growth
• Operationally defined as
controlling inflation to be
less 2% in Harmonized
Index Consumer Prices
(HICP).
• There is no exact figure as
reference of the price
stability and inflation.
• In evaluating the financial
market condition, (M3) as
quantitative reference.
• Board of Governor and
FOMC maintain growth of
money and credit in line
with the long-run economic
performance such as
employment rate, inflation
rate, and moderate interest
rate.
• Prediction of inflation and
the risk price stability is
crucial (broad based
assessment)
32
Monetary Policy Framework
•
ECB announces target of
money growth periodically
since its inception
•
Using M3 as the evaluation
tool to the financial market
condition has some
technical problem.
•
M3 is defined as currency,
deposits, and marketable
securities held by Euroarea resident.
•
The fed has been
announcing the target of
money growth since 2002.
•
The Fed does not have such
kind of problems
33
Operational Procedure :
Both central banks use the similar tools but
different method in managing money market and
influencing short-term interest rate
1. The ECB influence the liquidity in
the market through the open
market operation based on
weekly pre-arranged schedule
The instrument used in this
operation is essentially
repurchase agreement like in the
Fed.
2.
ECB uses minimum reserve to
stabilize money market interest
rates. The ECB requires bank to
hold required reserve based on
the level of the liabilities.
1. The Fed uses the Open Market
Operation through over-night
repurchase agreement in
influencing market liquidity and.
the two other tools, i.e reserve
requirement and discount rate.
Level of supply is determined
every morning based on forecast
for reserve demand.
2. Reserve requirement is not used
to influence inflation and growth,
but to stabilize the demand for
reserve to make easier to control
the fed fund rate.
34
Operational Procedure :
3.
ECB also provides
overnight loans to banks
with the marginal lending
rate. The spread is
determined by governing
council.
3. The Fed provide loan at the
discount window. The discount
rate is subject to approval from
the board of governors.
4.
The open market
operations are done
simultaneously by the NCB
in the Euro-system.
4. Estimate the demand for
reserves, and estimates the
supply before any other open
market operation, and arrange
additional open market
operations.
5.
The OMO involving
coordination among 15
NCB and hundreds financial
institutions. It becomes
more complicated.
5. The Fed conducts the OMO
through the Fed of NY and
involving a fewer financial
institution.
35
Operational Procedure :
6. Due to the differences in
financial structure among the
countries, ECB deals with more
various collateral
6.The Fed only deals with the US
government securities as
collateral.
7. The sheer volume of funds that
is refinanced on regular basis
is larger than that of the Fed
therefore ECB set up more
cumbersome and risky.
36
PART III: Monetary Policy

Macroeconomic Performance

Monetary Policy Instruments

Monetary Policy Strategies
37
Key economic characteristics of the Euro Area, US and Japan
38
Unemployment rate in the Euro Area, the United States and Japan
39
40
Monetary Instruments
41
Tools of Monetary Policy of Federal Reserve and ECB
42
The instruments of ECB’s monetary policy
1.


Open market operations
The main refinancing operations are
regular liquidity-providing reverse transactions
with a weekly frequency and a maturity of two
weeks.
The longer-term refinancing operations
are liquidity-providing reverse transactions with
a monthly frequency and a maturity of three
months.
43
The instruments of ECB’s monetary policy


Fine-tuning operations can be executed on an ad
hoc basis with the aim of both managing the
liquidity situation in the market and steering interest
rates, in particular in order to smooth the effects on
interest rates caused by unexpected liquidity
fluctuations.
In addition, the Eurosystem may carry out
structural operations through the issuance of
debt certificates, reverse transactions and outright
transactions.
44
45
The instruments of ECB’s monetary policy
2.
Standing facilities aim to provide and absorb
overnight liquidity, signal the general monetary
policy stance and bound overnight market interest
rates.


Marginal lending facility, is used by
counterparties to obtain overnight liquidity from the
NCBs against eligible assets.
Deposit facility to make overnight deposits with
the NCBs.
46
The instruments of ECB’s monetary policy
3. Minimum reserves
 The Governing Council of the ECB has decided to
apply minimum reserves as an integral part of the
operational framework for the monetary policy in
Stage Three.
47
Three Tools of Federal Reserve Monetary
Policy
1.Establishing reserve requirements, the minimum
proportion (percentage) of bank deposits they must keep
on deposit at the Fed.



Increasing reserve requirements (%) increases the
percentage of bank deposits kept in non-interest
bearing deposits at the Fed and limits bank lending.
Decreasing reserve requirements (%) reduces the
percentage of bank deposits kept in the Fed and
provides the banking system with excess reserves.
Bank deposits (reserves) in the Fed are needed to
clear checks and to satisfy reserve requirements.
48
Three Tools of Federal Reserve Monetary
Policy (Continued)
Open market operations affect the level of member
bank reserves and the monetary base.
2.


Buying government securities from the private sector,
the Fed eventually credits member bank deposits, thus
increasing the level of bank reserves and the banks'
ability to make loans and expand the money supply.
Selling securities (could be any asset) to private security
dealers or banks, the Fed is paid with a bank check
which reduces the level of member bank actual reserves
49
50
Three Tools of Federal Reserve Monetary
Policy (Continued)
Discount Rate Policy -- The rate of interest
depository institutions pay for borrowing from the Fed.
3.


Raising the discount rate increases the cost of
borrowing for needed reserve balances.
Lowering the discount rate lowers the cost of bank
liquidity and encourages lending and money supply
expansion.
51
Monetary Policy Strategy
52
53
54
55
An illustration of the transmission mechanism from interest rates to prices
56
57
58
Two Pillars of ECB’s Monetary Policy Strategy
59
First Pillar of ECB’s Monetary Policy Strategy: Economic
analysis
1.
The Economic Analysis focuses mainly on the
assessment of current economic and financial
developments and the implied short to medium-term risks
to price stability. Includes:

Analysis of real economy indicators.

Analysis of financial market developments.

Analysis of exchange rate developments.

Euro area macroeconomic projections based on
technical assumptions, models and technical
expertise of staff
60
Second Pillar of ECB’s Monetary Policy Strategy: Monetary
analysis
2.



Monetary analysis focuses on a longer-term horizon,
exploiting the long-run link between money and prices.
The monetary analysis mainly serves as a means of
cross-checking, from a medium to long-term
perspective, the short to medium-term indications for
monetary policy coming from the economic analysis.
Includes:
The analysis of special factors
A comprehensive assessment of liquidity and
credit conditions
Analysis of components and counterparts of M3
61
62
63
Conclusion


There is no blueprint for the structure and
operations of a central bank. Although the
structures of the Federal Reserve System and
the Eurosystem are similar, there are many
differences in the way they operate.
The Eurosystem is more decentralized than the
Federal Reserve.
64
Conclusion

There is lesson for Fed to take from ECB:

To clarify the goals of monetary policy.



Disagreements remain over how to best make policy
transparent while at the same time reserving the independence
of the central banks.
Transparency of two FED and ECB has also increased.
It is harder for the ECB to forecast the monetary magnitude
compared with the Fed due to the relatively limited data
available from the past (only 5 years)
65