Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ
Chapter Sixteen
The Structure of Central Banks: The Federal
Reserve and the European Central Bank
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Introduction
• Between 1870 and 1907, the nation
experienced 21 financial panics of varying
severity.
• During the Panic of 1907, an astonishing twothirds of banks founds themselves temporarily
unable to redeem deposits.
• In the intervening centuries, Europeans had
developed a system of central banks.
American had not.
16-2
Introduction
• The prevailing philosophy of many 19thcentury Americans was that centralized
government of any form should be kept to a
minimum.
• But punishing effects of frequent financial
panics led people to reconsider the merits of a
powerful central banks.
• In 1913, Congress passed the Federal Reserve
Act.
• This created the U.S. Federal Reserve System.
16-3
Introduction
• While central banking had stabilized European
financial systems before 1900, the 20th century
was another story.
• Europe experienced high inflation rates, low
growth, high and volatile interest rates, and
unstable exchange rates.
• After two world wars, governments’ free
spending led to unrelenting fiscal deficits.
16-4
Introduction
• Leaders came to believe that the only way to
ensure both political and economic stability
was to forge closer ties among the continent’s
countries.
• The result was the European monetary union,
with its common currency, the euro, and its
central bank, the European Central Bank
(ECB).
• This chapter examines these two central banks
and how their structure helps them to meet
their objectives.
16-5
The Structure of the Federal Reserve
System
• The Federal Reserve Act established a system
that is composed of three branches with
overlapping responsibilities:
• Twelve regional Federal Reserve Banks, distributed
throughout the country;
• A central governmental agency, called the Board of
Governors of the Federal Reserve System, in
Washington, D.C.; and
• The Federal Open Market Committee.
16-6
The Structure of the Federal Reserve
System
• In addition, a series of advisory committees
make recommendations to the board and the
Federal Reserve Banks.
• Finally, there are the private banks that are
members of the system.
• This complex structure diffuses power in a way
that is typical of the U.S government.
• It creates a system of checks and balances that
reduces the tendency for power to concentrate at the
center.
16-7
The Structure of the Federal Reserve
System
• All national banks are required to belong to the
Federal Reserve System.
• State banks that receive their charters from
individual state banking authorities have the
option of joining, but fewer than 20% do.
16-8
The Federal Reserve Banks
• The Federal Reserve Bank of New York has
the largest gold vault in the world.
• All of this gold belongs to foreign countries and
international organizations like the International
Monetary Fund.
• It is also the largest of the 12 Federal Reserve
Banks which together with their branches form
the heart of the Federal Reserve System.
• All 12 have cash vaults, but only New York has
gold.
16-9
The Federal Reserve System:
The Twelve Districts
16-10
The Federal Reserve Banks
•
•
•
The lines separating the regions for the
Federal Reserve System were drawn in 1914,
so they represent population density at that
time.
Politicians decided that no district should
coincide with a single state.
The purpose of this is twofold:
1. To ensure that every district contains as broad a
mixture of economic interests as possible, and
2. To ensure that no person or group can obtain
preferential treatment from the Reserve Bank.
16-11
The Federal Reserve Banks
• Reserve Banks are part public and part private.
• They are federally chartered banks and private,
nonprofit organizations, owned by the
commercial banks in their districts.
• They are overseen by both their own boards of
directors and the Board of Governors.
• The method for choosing the nine members of
the boards of directors ensures the inclusion of
not only bankers but other business leaders and
people who represent the public interest.
16-12
The Federal Reserve Banks
• Six directors are elected by the commercial
bank members.
• The remaining three are appointed by the
Boards of Governors.
• Each Reserve Bank has a president who is
appointed for a five-year term by the bank’s
board of directors with the approval of the
Board of Governors.
16-13
The Federal Reserve Banks
• The Government’s Bank
• Issues currency,
• Maintains the Treasury’s account, and
• Manages the Treasury debt.
• The Bankers’ Bank
•
•
•
•
•
Holds Reserve Deposits,
Operates the Payments System,
Makes Discount Loans at the Discount Rate,
Supervises and regulates financial institutions, and
Collects Data.
16-14
Only the New York Fed
Branch:
•Auctions Treasury Securities,
•Provides Foreign Government
Services,
•Completes Monetary Policy
Operations, and
•Runs Fedwire: Large Value
Interbank Funds Transfer System.
16-15
The Federal Reserve Banks
• The Federal Reserve’s own portfolio is managed at the
Federal Reserve Bank of New York through what we
called open market operations.
• In the crisis of 2007-2009, the Federal Reserve Bank of
New York also operated a variety of special new
liquidity and credit facilities that supplied funds to
intermediaries and allowed with Fed to acquire a
portfolio of non-Treasury assets.
16-16
The Federal Reserve Banks
• Finally, the Reserve Banks play an important
part in formulating monetary policy:
• Through their representation on the Federal Open
Market Committee (FOMC), and
• Through their participation in setting the discount
rate.
• The discount rate is the interest rate charged on
loans to commercial banks.
16-17
The Federal Reserve Banks
• The Federal Reserve Act specifies that the
discount rate is to be set by each of the Reserve
Bank’s board of directors, with approval of the
Board of Governors.
• Technically, it is done this way.
• However, it is set automatically at a premium
above the overnight interest rate that the
FOMC controls.
• The directors have virtually no say over the
discount rate.
16-18
The Board of Governors
• The seven members of the board, who are
called governors, are appointed by the
president and confirmed by the U.S. Senate for
14-year terms.
• The long terms are intended to protect the
board from political pressure.
• The terms are staggered limiting any individual
president's influence over the membership.
16-19
The Board of Governors
• The board’s membership usually includes
academic economists, economic forecasters,
and bankers.
• No two governors can come from the same
Federal Reserve district.
• The Federal Reserve Act explicitly requires “a
fair representation of the financial, agricultural,
industrial, and commercial interests.”
16-20
The Board of Governors
• Duties of the governors are to:
• Set the reserve requirement,
• Approve or disapprove discount rate
recommendations,
• Administer consumer credit protection laws,
• Supervise and regulate the Reserve Banks,
• Along with the Reserve Banks, regulate and
supervise the banking system,
• Invoke the emergency powers to lend to nonbanks,
• Analyze financial and economic conditions, and
• Collect and publish detailed statistics.
16-21
The Board of Governors
• The seven governors do not have their own
support staff.
• They request help and information from the
managers of various departments, who assign
individuals to specific tasks.
• The managers answer to the chair of the Board
of Governors.
16-22
• Treasury Direct allows individuals to purchase
U.S. Treasury securities without the use of a
broker or dealer.
• With as little as $1000 you can start an account and
purchase bonds, notes, or bills through the Fed.
• You do it at the auction using a noncompetitive
bid.
• This guarantees you will receive the bond you want
at the average auction price.
• The Fed will sell your bonds at the highest
market price available.
16-23
The Federal Open Market Committee
• When the press discusses the Fed, their focus is
generally on the Federal Open Market
Committee (FOMC).
• This group sets the interest rates to control the
availability of money and credit to the economy.
• It has existed since 1936 and has 12 voting
members:
• The seven governors,
• The president of the Federal Reserve Bank of
New York, and
• Four Reserve Bank presidents.
16-24
The Federal Open Market Committee
• The chair of the Board of Governors chairs the
FOMC.
• The committee’s vice chair is the president of
the Federal Reserve Bank of New York.
• While only 5 of the 12 Reserve Bank
presidents vote at any one time, all of them
participate in the meeting.
16-25
The Federal Open Market Committee
• The FOMC could control any interest rate, but
it chooses to control the federal funds rate.
• This is the rate banks charge each other for
overnight loans on their excess deposits at the Fed.
• By controlling the federal funds rate, the
FOMC influences real growth.
16-26
The Federal Open Market Committee
• The FOMC currently meets 8 times a year.
• During times of crisis, the committee can
confer and change policy over the telephone.
• Because these “inter-meeting” policy shifts signal
the financial markets that the FOMC believes
conditions are dire, they are reserved for
extraordinary times.
• The financial crisis of 2007-2009 prompted 12
unscheduled FOMC meetings.
16-27
The Federal Open Market Committee
• The primary purpose of a meeting is to decide
on the target interest rate.
• The FOMC itself does not engage in the
financial market transactions that are required
to keep the market federal funds rate near this
target or to manage the Fed’s portfolio.
• That is the job of the system open market
account manager who works for the Federal
Reserve Bank of New York.
16-28
The Federal Open Market Committee
• Three important documents are distributed to
all attendees prior to each meeting:
• The beige book,
• The green book, and
• The blue book.
• The beige book is a compilation of anecdotal
information about current business activity.
• This is the only FOMC document that is released to
the public before the meeting.
16-29
The Federal Open Market Committee
• The green book contains the Board staff’s
economic forecast for the next few years.
• The blue book is a discussion of financial
markets and current policy options.
• Both the blue and green books are distributed
electronically the week before the meeting.
• They are both treated as secret documents and
are not released to the public for 5 years after
the meeting.
16-30
The Federal Open Market Committee
• An FOMC meeting is a formal proceeding that
can be divided into two parts, each beginning
with a staff report followed by a round of
discussion that includes all the meeting’s
participants.
• There is a specific order in which people speak at
these meetings.
• Three weeks after the meeting, detailed
minutes summarizing the deliberations are
released on the FOMC’s public Web site.
16-31
The Federal Open Market Committee
•
To see where the committee’s power lies and
who controls interest-rate decisions, we can
look at a few things.
1. The chair is the voice of the Fed.
2. The governors make up a majority of the
committee.
3. Beyond the beige book, the most important
information regularly distributed to all committee
members are the green and blue book both
prepared by the Federal Reserve Board staff,
controlled by the chair.
16-32
The Federal Open Market Committee
4. The chair sets the agenda for FOMC meetings,
determines the order in which people speak, and
proposes the FOMC policy statement.
5. Although votes are made public immediately after
the meeting, committee members observe a
blackout period from a week prior to a week after
the meeting.
• And don’t forget the Board of Governors controls
the Reserve Banks’ budgets and salaries of their
presidents.
16-33
The Federal Open Market Committee
• The chair of the Fed is the FOMC’s most
important member.
• Listen to this person to see what the FOMC is going
to do.
• While the chair is very powerful, the
committee structure provides an important
check on his/her power.
• Even two dissents on an FOMC votes are unusual.
• Three dissents would raise doubts about the chair’s
leadership.
16-34
User’s Guide to the Fed
16-35
• As the financial crisis deepened in 2008, the
range of FOMC policy actions broadened.
• The form of the FOMC statement released at
the end of the FOMC’s regularly scheduled
meetings changed markedly.
• Interpreting these statement takes some
practice, especially in such extraordinary
circumstances as a financial crisis.
16-36
Assessing the Federal Reserve System’s
Structure
• In the last chapter we said that an effective
central bank is one in which:
•
•
•
•
Policymakers are independent of political influence,
Make decisions by committee,
Are accountable and transparent, and
State their objective clearly.
• Let’s evaluate the Fed using these criteria.
16-37
Independence from Political Influence
• There are three criteria for judging a central
bank’s independence:
• Budgetary independence,
• Irreversible decisions, and
• Long terms.
• The Fed meets each of these.
16-38
Independence from Political Influence
• The Fed controls its own budget.
• Their substantial revenue comes from interest on
government securities it holds and fees charged to
banks for payments system services.
• Typically 95% of its income is returned to the U.S.
Treasury each year.
• Interest rate changes are implemented
immediately and can be changed only by the
FOMC.
• The terms of the governors are 14 years,
chair’s term is 4 years, and Reserve Bank
presidents serve for 5 years.
16-39
Decision Making by Committee
• The Fed clearly makes decision by committee,
because the FOMC is a committee.
• While the chair of the Board of Governors may
dominate policy decision, the fact that there are
12 voting member provides an important
safeguard against arbitrary action.
16-40
Accountability and Transparency
• The FOMC releases huge amount of information to the
public:
•
•
•
•
•
The beige book,
Announcement of policy decision with explanatory statement,
Detailed minutes of the meeting 3 weeks later,
Word-for-word transcript 5 years later,
Quarterly reports of the committee participants’ outlook for
economic growth and inflation over the next 3 years,
• Twice-yearly “Monetary Policy Report to the Congress”,
• The chair’s appearance before Congress to discuss the state of
the nation’s economy, and
• Numerous speeches given by the chair, other governors and
Reserve Bank presidents.
16-41
Accountability and Transparency
•
A few things are missing from the Fed’s
communications:
1. There is not regular press conference, nor any real
questioning of the chair on the FOMC’s current
policy stance.
2. The inputs into the decision-making process and
the meeting transcript are not made pubic until
five years after the fact.
3. The fact that the committee has been hesitant to
state its objectives clearly and concisely hampers
communication.
16-42
•
Two events provide the foundation for Fed
independence:
1.
2.
In 1935, political appointees were removed from the Federal
Reserve Board, and the FOMC was created.
In 1951, President Truman supported the Fed’s refusal to
purchase Treasury securities that the Secretary of the
Treasury requested they buy.
• The president, the secretary of the Treasury, and the
Federal Reserve chair reached an “accord” and issued a
joint announcement establishing the FOMC’s
independence in setting interest rates and controlling the
rate of monetary expansion.
16-43
Policy Framework
• The Congress of the U.S. has set the Fed’s
objectives:
“The Board of Governors of the Federal Reserve
System and the Federal Open Market
Committee 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 longterm interest rates.”
16-44
Policy Framework
• Prior to becoming chairman, Ben Bernanke
argued that the best way to make monetary
policy is to announce a specific numerical
objective for inflation over some time horizon.
• So far, the FOMC has moved closer to this
approach by publishing the committee
participants’ long-term inflation forecasts.
• However, the FOMC still does not publish a
target that represents the committee’s
consensus.
16-45
• The Fed does its best to stabilize the economy.
• The stock market goes up and down regardless
of what the Fed does.
• The Fed does not control the stock market and
will react to movements only in so far as they
comprise its inflation and growth objectives.
• No one can eliminate the risk that is inherent in
an investment - not even the most powerful
central bank in the world.
16-46
The European Central Bank
• On January 1, 1999, the majority of Western
European countries adopted a common
currency.
• Purchases are made in euros, and monetary
policy is the job of the European Central Bank
(ECB).
• By 2010, the euro had become the currency of
16 countries.
16-47
The European Central Bank
• The agreement to form a European monetary
union was formalized in the Treaty of
Maastricht.
• It ultimately led to the creation of the European
system of Central Banks (ESCB).
• The ESCB is composed of the National Central
Banks (NCBs) in the 27 countries in the European
Union.
16-48
The European Central Bank
• The ECB and the NCBs of the 16 countries that
participate in the monetary union make up
what is known as the Eurosystem.
• They share a common currency and common
monetary policy.
• We will refer to the institution that is
responsible for monetary policy in the euro
area as the European Central Bank.
16-49
16-50
Organizational Structure
• The eurosystem mirrors the structure of the
Federal Reserve System in several ways.
• There is a six-member Executive Board of the ECB,
similar to the Board of Governors;
• The National Central Banks play many of the same
roles as the Federal Reserve Banks; and
• The Governing Council formulates monetary policy
as the FOMC does.
16-51
Organizational Structure
• The Executive Board has a president and a vice
president who play the same role as the Fed’s
chair and vice chair.
• Executive Board members are appointed by a
committee composed of the heads of state of
the countries that participate in the monetary
union.
16-52
Organizational Structure
16-53
Organizational Structure
• The ECB and the NCBs together perform the
traditional operational functions of a central
bank.
• They use interest rates to control the availability of
money and credit in the economy, and
• They are responsible for the smooth operation of
the payments system and the issuance of currency.
• The National Central Banks continue to serve
as bankers to the banks and governments in
their countries.
16-54
Organizational Structure
•
There are several important differences
between the Fed and the ECB.
1. The ECB does not supervise and regulate financial
institutions.
2. The implementation of monetary policy is
accomplished at all the national central banks,
rather than being centralized as in the U.S.
3. The ECB’s budget is controlled by the National
Central Banks, not the other way around.
16-55
Organizational Structure
• The focus of the ECB’s activity is on monetary
policy.
• The Governing Council is composed of the six
Executive Board members and the governors of
the 15 central banks in the euro area.
• Meetings are held monthly.
• Decisions are made by consensus; no formal
votes are taken.
• The Governing Council members are charged with
setting policy for the euro area as a whole,
regardless of economic conditions in the individual
countries.
16-56
Organizational Structure
•
A number of important safeguards were
included in the Treaty of Maastricht to ensure
the central bank’s independence.
1. There are terms of office.
2. The ECB’s financial interests must remain
separate from any political organization.
3. The treaty states explicitly that the Governing
Council cannot take instructions from any
government, so its policy decisions are
irreversible.
16-57
Organizational Structure
• There will be more countries who want to enter
the monetary union and some difficult
decisions must be made.
• ECB’s membership would be 6 executive board
members and one representative from each of the
member countries - a possible total of 33 members.
• The Governing Council of the ECB has
adopted a complex system of rotation to be
implemented when country membership
reaches 19 states.
• It bears a passing resemblance to the system used
by the FOMC.
16-58
Accountability and Transparency
• Like the Fed, the ECB distributes large
volumes of information in all of the ECB’s
official languages.
• Included are:
•
•
•
•
•
•
A weekly balance sheet;
A monthly statistical bulletin;
An analysis of current economic conditions;
Biannual forecasts of inflation and growth;
Research reports relevant to current policy; and
An annual report.
16-59
Accountability and Transparency
• The most important aspect of the ECB’s
communication strategy concerns statements about the
Governing Council’s policy deliberations.
• Following each of the Governing Council’s monthly
meetings, the president and vice president of the ECB
hold a news conference.
• This contrasts the statement and refusing to answer questions
after its meeting by the FOMC.
• However, the ECB does not make minutes public for
20 years.
16-60
Accountability and Transparency
•
In assessing whether the ECB’s
communications strategy is sufficient, we
need to ask two questions:
1. Does the information that is released minimize the
extent to which people will be surprised by future
policy actions?
2. Does it hold policymakers accountable for their
decisions?
•
The answer is yes to both questions.
16-61
• Ben Bernanke wrote about the virtues of central
banks adopting inflation targets.
• The adoption of a new policy framework
depends on building political support both
among the members of the FOMC and in the
U.S. Congress.
• Under Chairman Bernanke, the FOMC gradually
adjusted its procedures to become more like
those of an inflation-targeting central bank.
• Has the FOMC announced an explicit inflation
target?
16-62
The Price Stability Objective and
Monetary Policy Strategy
The Treaty of Maastricht states:
“The primary objective of the European System
of Central Banks shall be to maintain price
stability. Without prejudice to the objective of
price stability, the ESCB shall support the
general economic policies in the Community.”
• This includes the objective of sustainable and
non-inflationary growth.
16-63
The Price Stability Objective and
Monetary Policy Strategy
• The Treaty is widely understood to place
priority on price stability as the top objective
for the ECB.
• The Governing Council’s response has been to
explain its interpretation of the statement and
describe the factors that guide its policy
decisions.
16-64
The Price Stability Objective and
Monetary Policy Strategy
The strategy has two parts:
1. There is a numerical definition of price stability,
and
2. The Governing Council announces its intention to
focus on a broad-based assessment of the outlook
for future prices, with money playing a prominent
role.
16-65
The Price Stability Objective and
Monetary Policy Strategy
• The ECB’s Governing Council defines price
stability as an inflation rate of close to, but less
than, 2 percent, based on a euro-area-wide
measure of consumer prices.
• This is the harmonized index of consumer prices
(HICP) and is similar to the CPI.
• It is the average of retail price inflation in all the
countries of the monetary union, weighted by the
size of their gross domestic products.
16-66
The Price Stability Objective and
Monetary Policy Strategy
• This arrangement has important implications
for monetary policy operations, because there
will surely be times when the proper policy for
Ireland is to raise interest rates but the proper
policy for Germany is to lower them.
• Given Ireland’s relative size, a change in inflation
or growth there has little impact on the euro area as
whole.
• The same is true for a number of other small
countries in the union.
16-67
The Price Stability Objective and
Monetary Policy Strategy
• The fact that the economically large countries
matter much more than the small ones can
affect the dynamics of the governing council’s
policymaking.
• While the governing Council’s job is to
stabilize prices in the euro area as a whole, one
wonders whether activities in the smaller
countries might have undue influence on its
policy decisions.
16-68
The Price Stability Objective and
Monetary Policy Strategy
• Evidence strongly suggests that the ECB is
doing the job it is supposed to do.
• The Governing council’s policy has been
appropriate to the euro area.
• It has not been skewed toward smaller countries’
concerns.
• The specificity of the price stability objective
holds policymakers accountable.
• It limits discretion in their decision making.
16-69
• The designers of the ECB introduced a rule that
forbids the ECB from directly helping a
government facing financial distress.
• This was the so-called no-bailout clause of the
Maastricht Treaty.
• In 2010, very large fiscal deficits of several
euro-area governments led to a widening of
yield spreads of their debt over German debt.
16-70
• Given the no-bailout rule, the burden of
preventing a disruption of sovereign borrowing
falls on euro-area fiscal leaders.
• In the spring of 2010, after posting the second
largest budget deficit of any euro-area country,
the Greek government experienced significant
problems borrowing.
• Euro-area nations teamed up with the IMF to
offer Greece large-scale loans at a cost below
market yields.
16-71
• This was, of course, provided that the Greek
government implement a set of stringent
budget reforms proposed by the IMF.
• It remains to be seen how successful the
program will be in securing long-run stability
in the region.
16-72
Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ
End of
Chapter Sixteen
The Structure of Central Banks: The Federal
Reserve and the European Central Bank
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.