Central banks and monetary policy

Central banks and monetary policy Central bank independence

What is central bank independence? • This refers to the degree of freedom granted to the central bank by the government to implement monetary policy • Independence may refer to instrument independence or goal independence • Instrument independence means the central bank can decide which tools of monetary policy to use • Goal independence means the central bank can decide its own targets for monetary policy

Arguments for independence • Removal of inflation-creating political control • Politicians may aim to increase voter numbers by stimulating the economy shortly before an election • This is inflationary and damaging to the macroeconomy • Reduced temptation to support government spending • Difference in engaging with the open market and buying bonds directly from government • Done by Zimbabwe  hyperinflation • Politicians are typically not financial / economic experts

Disadvantages of independence • An independent central bank is undemocratic • Decisions are made by individuals who are not elected by the public • There may be a disjoint between fiscal and monetary policy • Effects of each may cancel the other out • Central banks can fail • However, so do politicians

Central banks and monetary policy Case study: Bank of England (UK)

Elements to consider • In this section, we will look at: • The history and development of the BoE from its creation to present-day • How it is organised • What it does

Foundations of the BoE • In the late 1600s, England was politically stable, commerce was doing well but public finances were in a bad state • There were calls for a national or public bank to mobilise resources • A loan to the government of £ was proposed • In return the subscribers would be incorporated as the Governor and Company of the Bank of England

National Debt • On 27 July 1694, the Bank started its role as the Government’s banker and debt manager • The was the • The Bank’s initial activity was dominated by the Government’s demands for finance and issuing new coinage • The Bank also began conventional banking activity (i.e. )

BoE Banknotes • As evidence of deposits, the Bank issued banknotes • These became money, since people rarely doubted the promise to pay the bearer on demand • At this time, • The Bank became the national treasure house and was the leading commercial bank • This happened, given: • its links with Government; • the scale of its private banking business; and • its position within the developing City of London’s financial system

Debt and inflation • The national debt increased to £ by the start of the 1800s (after a period of war) • The wars put a strain on the government’s finances • 1797 – 1821 was a restriction period where the Bank in exchange for banknotes, due to the drain on reserves • Since there were a lack of coins, £1 and £2 notes were issued • This led to inflation and there was economic difficulty after the wars when financial discipline was restored

Extension of commercial banking activities • In the early 19th century (1800s), the Bank was not the sole note issuer • Many “country” banks issued their own notes • However, they were prone to failure • Particularly due to the difficult economic climate post-Napoleonic wars • In order to meet demand for sound banknotes, the Bank began from 1828 to

Becoming the sole note issuer • In 1844, the Bank Charter Act (BCA) was written • This gave the Bank a formal in England and Wales • Scottish banks were permitted to continue printing notes • But those were required to be • At this point, the Bank became the for the UK

Developing a stable currency • Within the BCA, there was an important condition: • The Bank was not permitted to issue further new notes that were not matched by an increase in its gold reserve • This was as a result of the previously generated inflation • The fiduciary issue was frozen at its 1844 level • The Bank was also required to publish its note-issuing activities separately to its banking activities • This continues in present day accounts for the Bank

Limitations and change • Although the 1844 BCA gave the Bank note issue and the nation a sound currency, it limited the Bank’s ability as a commercial bank • In the 19th century, it was overtaken in size • The Bank chose not to compete and instead to develop its role as a central bank

Development as a central bank • The LLR function was established in a series of banking crises • When necessary, it mobilised its own resources and those of the City when a crisis at a single institution threatened the system as a whole • The Bank routinely used its leverage over the banking system’s liquidity to set interest rates in London • The gold standard limited the choice of interest rates • The rates needed to be high enough to maintain its gold holdings

Departure from the gold standard • WWI required financing – notes were issued by HM Treasury • Those low denomination notes were • In 1925, an attempt was made to return to the gold standard • This was unsustainable • In 1931, the gold standard was abandoned & the currency became fiat • Now to issue more notes, • Gold and foreign exchange reserves were transferred to HM Treasury in 1931

Increased functions and official status • During WWII, additional functions were given to the Bank • The Bank, historically, had typically acted in the national interest & fulfilled functions of a central bank • However, • occurred in 1946 • Ownership of the Bank transferred from to • This gave the Government more power in theory, however little changed in practice

The modern-day BoE • There were a number of changes in 1997 • Monetary policy granted to the Bank • Management of Government debt transferred • Regulatory functions transferred • The financial crisis identified problems with the 1997 system of regulation • The Financial Services Act 2012 returned many regulatory functions to the Bank, effective from 1st April 2013

The Court of the BoE • The Court of Directors comprises the most senior members of the organisation: • The Governor (head of BoE) • 3 Deputy Governors • Monetary policy, financial stability, prudential regulation • 9 Non-Executive Directors • These individuals have very strong reputations within the banking & financial system • Governors are appointed for 5 years, Directors for 3 years

Responsibilities • Monetary system stability & monetary policy • Setting interest rates, dealing with fluctuations in liquidity • Payment systems oversight & strengthening to reduce systemic risk • Macroprudential regulation • Authorisation and microprudential supervision of FIs • Note issuance • LLR in some instances • Intervention in FX markets • Management of remaining gold reserves

The Monetary Policy Committee (MPC) • The MPC meets once per month in the presence of a member of staff from HMT • The MPC members are provided with extensive briefing throughout the month on economic issues, including trends and expectations • The MPC meeting lasts for two days • Day 1: an update on economic data and discussion of key issues • Day 2: a summary of the discussions, individual explanations by MPC members on their proposed policy, the Governor puts forward policy that he believes will command a majority and MPC members vote (minority voters identify what they would have preferred) • The announcement on the decision is then made at 12:00 noon

Central banks and monetary policy Case study: European Central Bank (EMU)

Structure of the case study • For the ECB, we will consider: • The history of the ECB, from foundation to present-day • How it is organised

Prelude (1) to the European Central Bank (ECB) • On 1st January 1994, the second stage of Economic and Monetary Union (EMU) was launched • The European Monetary Institute (EMI) was founded to • In December 1995, the single currency was named as the euro and 1st January 1999 was identified as the beginning of the 3rd (final) stage of EMU

Prelude (2) to the European Central Bank (ECB) • In June 1997, the Stability and Growth Pact was adopted & an intra-EU exchange rate mechanism (ERM II) identified to start on 1st January 1999 • Aim: • In November 1997, the EMI proposed 1st January 2002 as the date for the introduction of • In May 1998, it was decided that 11 EU member states had fulfilled convergence criteria and would adopt the euro (in principle) on 1st January 1999

Creation of the ECB • May 1998 saw the confirmation of appointment of the forthcoming ECB’s President, Vice-President and 4 Executive board members • Appointed by the Council of the European Union in the composition of Heads of State or Government • The ECB was established on 1st June 1998, taking over from the EMI in preparation for 3rd stage integration • The executive board began work and held its first meeting the following day • Later in 1998, the Governing Council of the ECB (see later slide) set out its monetary policy strategy

The beginning of transition in practice • On 31st December 1998, conversion rates are set for each country to the euro • These figures are • On 1st January 1999, the euro launches in principle, alongside the national currencies • The ECB takes over for • The ECB + national central banks (NCBs) form the Eurosystem • Production of banknotes begins in July, in preparation for rollout in 2002 • Distributed to commercial banks in September 2001

Bodies of the ECB: the Governing Council • The Governing Council is the main decision-making body • The responsibilities of the GC are to: • Adopt guidelines & take decisions to ensure • Formulate monetary policy for EMU ( independence) • Frequency • Usually 2 meetings per month • Meeting 1: assessment of economic & monetary developments and a decision on monetary policy is made • Meeting 2: discussion of issues related to other tasks of the ECB

Bodies of the ECB: the General Council • The General Council includes the President of the ECB, the V-P of the ECB and the governors of the national central banks (NCBs) of all EU members • Responsibilities / functions include (but are not limited to): • Acting as a transitional body from the EMI since not all EU members are EMU members • Contributing to ECB advisory function and collects statistical information • Preparing the ECB’s annual report • Establishing rules for standardising the accounting and reporting of operations undertaken by the NCBs • When (or if!) all EU member states join the Euro, the General Council will be dissolved

Central banks and monetary policy Learning outcomes

On successful completion of the topic… • You should be able to: • Explain functions of a central bank (to include tools and targets of monetary policy) • Regarding monetary policy and given the nature of the module, emphasis here should be placed on open market operations • Note: the concept of CB as financial regulator should be introduced here and dealt with in more detail within topic 8 • CB independence • Explain and evaluate the case for an independent CB • Bank of England as a case study • European Central Bank as a case study • Federal Reserve Bank as a case study (see the textbook)

Central banks and monetary policy Further work

Next steps for you… • Complete your vocabulary list and learn it • Compulsory reading • Arnold (2012) – chapter 7 • Howells and Bain (2007) – chapter 3.1 • Mishkin and Eakins (2012) – chapters 9 and 10 • Additional reading • See the reference list

Central banks and monetary policy References

References • Arnold, G. (2012) Modern Financial Markets and Institutions: A Practical Perspective. Essex: Pearson Education. • (see the end of chapter 7) • Bank of England www.bankofengland.co.uk [various pages within the site are relevant] • Howells, P. and Bain, K. (2007) Financial Markets and Institutions. (5th Edition). Essex: Pearson Education. • (see chapter 3.1) • Mishkin, F.S. and Eakins, S.G. (2012) Financial Markets and Institutions. (7thGlobal Edition). Essex: Pearson Education. • (see chapters 9 & 10)

Central banks and monetary policy