LEARNING OBJECTIVES

LEARNING OBJECTIVES After studying this chapter, you should be able to: Explain why the Federal Reserve System is structured the way it is. 13.1 Explain the key issues involved in the Fed’s operations. 13.2 Discuss the issues involved with central bank independenceoutside the United States. 13.3

Has the Fed Become Too Powerful? • In 2010, the Dodd-Frank Act authorized an audit of the Fed’s emergency lending programs. • In 2012, the House of Representatives authorized the General Accounting Office to audit the monetary policy actions of the Fed. • Many economists and Fed chairman Ben Bernanke saw this as an attempt to reduce the Fed’s independence. • Others believe that the Fed has assumed a far too important role in the economy.

Key Issue and Question Issue: Following the financial crisis, Congress debated reducing the independence of the Federal Reserve. Question: Should Congress and the president be given greater authority over the Federal Reserve?

13.1 Learning Objective Explain why the Federal Reserve System is structured the way it is.

The Structure of the Federal Reserve System The Structure of the Federal Reserve System Creation of the Federal Reserve System • The Bank of the United States was created to function as a central bank. Local banks resented the Bank’s supervision of their operations. • Congress granted the Bank a 20-year charter in 1791, but it ceased operations in 1811 due to a lack of support to renew its charter. • In 1816, Congress established the Second Bank of the United States. The Bank encountered the same controversies as the First Bank and its charter expired in 1836. • The Federal Reserve Act of 1913 created the Federal Reserve System after severe nationwide financial panics in the late 1800’s, which raised fears that the U.S. financial system was unstable without a central bank.

Federal Reserve System is the central bank of the United States. • Economic power within the Federal Reserve System is divided in 3 ways: • 1. Among bankers and business interests • 2. Among states and regions • 3. Between government and the private sector • Four groups within the system were empowered to perform separate duties: • 1. The Federal Reserve Banks • 2. Private commercial member banks • 3. The Board of Governors • 4. The Federal Open Market Committee (FOMC) • All national banks (chartered by the federal government) were required to join the system. • State banks (chartered by state governments) were given the option to join. The Structure of the Federal Reserve System

Federal Reserve Banks Federal Reserve Bank is a district bank of the Federal Reserve system that, among other activities, conducts discount lending. Federal Reserve Districts Figure 13.1 Division of the United States into 12 Federal Reserve districts.

Making the Connection St. Louis and Kansas City? What Explains the Locations of the District Banks? • When the Fed was created, district banks were intended to have much more independence than they have today. • The Reserve Bank Organizing Committee was given the task of determining district boundaries. • There was agreement about six of the cities: Boston, Chicago, New York, Philadelphia, St. Louis, and San Francisco. • A study concluded that economic variables could correctly predict the cities chosen, while political factors could not. • So, while it may seem odd today for Missouri to have two Federal Reserve Banks, it appears to have made economic sense in 1914. The Structure of the Federal Reserve System

Who owns the Federal Reserve banks? • When banks join the Federal Reserve System, they are required to buy stock in their District Bank. So, the member banks own the District Bank. • To prevent one constituency from exploiting the central bank’s power at the expense of another, Congress restricted the composition of the boards of directors of the District Banks. • The directors represent the interests of three groups: • 1. Banks • 2. Businesses • 3. The general public • Member banks elect three bankers (Class A directors) and three leaders in industry, commerce, and agriculture (Class B directors). • The Fed’s Board of Governors appoints three public interest directors (Class C directors). The Structure of the Federal Reserve System

Functions of District Banks: • Manage check clearing in the payments system • Manage currency in circulation by issuing new Federal Reserve notes and withdrawing damaged notes from circulation • Conduct discount lending by making and administering discount loans to banks within the district • Perform supervisory and regulatory functions such as examining state member banks and evaluating merger applications • Collecting and making available data on district business activities and publishing articles on monetary and banking topics • Serve on the FOMC, the Federal Reserve System’s chief monetary policy body The Structure of the Federal Reserve System

The Federal Reserve District Banks engage in monetary policy both directly (by making discount loans) and indirectly (through membership on Federal Reserve committees). • In recent decades, the discount rate has been set by the Board of Governors in Washington, DC, not by the District Banks. • The District Banks also influence policy through their representatives on the FOMC and on the Federal Advisory Council, a consultative body composed of district bankers. The Structure of the Federal Reserve System

Member Banks • Currently, only about 16% of state banks and about one-third of all banks are members of the Federal Reserve System. • Historically, state banks often chose not to join because they saw membership as costly. Banks could also avoid the Fed’s reserve requirements. • The opportunity cost of being a member of the Fed increased during the 1960s and 1970s as nominal interest rates rose, and fewer state banks elected to become or remain members. • The Fed argued that declining bank membership eroded its ability to control the money supply and urged Congress to compel all commercial banks to join the Federal Reserve System. • Congress has not yet legislated such a requirement, but DIDMCA of 1980 required that all banks maintain reserve deposits with the Fed on the same terms. The Structure of the Federal Reserve System

Solved Problem 13.1 How Costly Are Reserve Requirements to Banks? Suppose that Wells Fargo pays a 1% annual interest rate on checking account balances, while having to meet a reserve requirement of 10%. Assume that the Fed pays Wells Fargo an interest rate of 0.25% on its holdings of reserves and that Wells Fargo can earn 5% on its loans and other investments. a. How do reserve requirements affect the amount that Wells Fargo can earn on $1,000 in checking account deposits? Ignore any costs Wells Fargo incurs on the deposits other than the interest it pays to depositors. b. Is the opportunity cost to banks of reserve requirements likely to be higher during a recession or during an economic expansion? Briefly explain. The Structure of the Federal Reserve System

Solved Problem Solved Problem 13.1 How Costly Are Reserve Requirements to Banks? Solving the Problem Step 1Review the chapter material. • Step 2 Answer part (a) by calculating the effective cost of funds to Wells Fargo. • With a 10% reserve requirement, Wells Fargo must hold $100 of a $1,000 checking account deposit in reserves, on which it receives an interest rate of 0.25%. • The bank can invest the remaining $900. So, it will earn: • ($900 x 0.05) + ($100 x 0.0025) = $45.25. • If the bank did not need to hold reserves, it would earn: $1,000 x 0.05 = $50. • So, the reserve requirement is reducing Well Fargo’s return by $4.75. • Step 3 Answer part (b) by explaining how the reserve tax varies over the business cycle. • The higher the interest rate banks can earn on loans, the higher the opportunity cost of having to hold reserves. • Interest rates tend to fall during economic recessions and rise during economic expansions (Chapter 4). So, the opportunity cost to banks of reserve requirements is likely to be higher during economic expansions. The Structure of the Federal Reserve System

Board of Governors Board of Governors is the governing board of the Federal Reserve System, consisting of seven members appointed by the president of the United States. • The Board of Governors is headquartered in Washington, DC. • Members are confirmed by U.S. Senate, and serve 14-year, nonrenewable terms. The terms are staggered so it is unlikely that one U.S. president will be able to appoint a full Board of Governors. • The president chooses one member of the Board of Governors to serve as chairman. Chairmen serve four-year terms and may be reappointed. • Board members are professional economists from business, government, and academia. The Structure of the Federal Reserve System

The Board of Governors: • Administers monetary policy: determines reserve requirements and sets the discount rate charged on loans to banks • Influences the setting of guidelines for open market operations • Informally influences national and international economic policy decisions • Advises the president and testifies before Congress on economic matters • Is responsible for some financial regulation, e.g., setting margin requirements and determining permissible activities for bank holding companies • Exercises administrative controls over individual Federal Reserve banks The Structure of the Federal Reserve System

The Federal Open Market Committee Federal Open Market Committee (FOMC)is the 12-member Federal Reserve committee that directs open market operations. • FOMC consists of the chairman of the Board of Governors, the other Fed governors, the president of the Federal Reserve Bank of New York, and the presidents of four of the other 11 Federal Reserve Banks (on a rotating basis). • The chairman of the Board of Governors serves as chairman of the FOMC. Only five Federal Reserve bank presidents are voting members of the FOMC, but all 12 attend meetings and participate in discussions. • The president of the Federal Reserve Bank of New York is always a voting member. The committee meets in Washington, DC, eight times each year. • Prior to each meeting, FOMC members access data from three books: • 1. Green Book: national economic forecast for the next two years • 2. Blue Book: projections for monetary aggregates • 3. Beige Book: summaries of economic conditions in each district. The Structure of the Federal Reserve System

The FOMC sets a target for the federal funds rate by buying and selling Treasury securities to adjust the level of bank reserves. • The FOMC doesn’t itself buy or sell securities for the Fed’s account. Instead, it issues a directive to the Fed’s trading desk at the New York Fed. • The manager for domestic open market operations carries out the directive by buying and selling Treasury securities with primary dealers (private financial firms that deal in these securities). The Structure of the Federal Reserve System

Making the Connection On the Board of Governors, Four Can Be a Crowd • The Government in the Sunshine Act of 1976 requires most federal government agencies to give public notice before a meeting. • If four or more members of the Board of Governors meet to consider a policy action, it is considered an official meeting and cannot be held without prior public notice. • During the financial crisis of 2007–2009, Fed Chairman Ben Bernanke instituted some unprecedented policy actions. • The requirement of prior public notice made it infeasible for him to meet with more than two other members in order to make decisions rapidly. So, Bernanke relied on an informal group of advisers consisting of Board of Governors members Donald Kohn and Kevin Warsh and New York District Bank president Timothy Geithner. • The “four musketeers” were the key policymaking body at the Fed for the duration of the crisis. The Structure of the Federal Reserve System

Power and Authority within the Fed • During its first 20 years, the decentralized District Bank system could not adequately respond to national economic and financial disturbances. • The Banking Acts of 1933 and 1935 centralized the Board of Governors’ control of the system, giving it a majority of seats (7 of 12) on the FOMC. • The secretary of the Treasury and the comptroller of the currency were also removed from the Board of Governors, thereby increasing the Fed’s independence. • The informal power structure within the Fed is more concentrated than the formal power structure. The Fed chairman is most powerful in the system. • The distinction between ownership and control is clear: Member banks own shares of stock, but this ownership confers none of the rights that are typically granted to shareholders of private corporations. The Structure of the Federal Reserve System

Organization and Authority of the Federal Reserve System Figure 13.2 The Federal Reserve Act of 1913 established the Federal Reserve System and incorporated a series of checks and balances into the system. The Structure of the Federal Reserve System

Changes to the Fed Under the Dodd-Frank Act Dodd-Frank Wall Street Reform and Consumer Protection Actis legislation passed during 2010 that was intended to reform regulation of the financial system. • Main provisions of the bill that affect the Fed: • The Fed was made a member of the new Financial Stability Oversight Council, which was charged with preventing the failure of large financial firms. • One member of the Board of Governors will coordinate the Fed’s regulatory actions. • The Government Accountability Office (GAO) was ordered to perform an audit of the Fed’s emergency lending programs. • Class A directors will no longer participate in elections of the bank presidents. • The Fed was ordered to disclose the names of financial institutions to which it makes loans and with which it buys and sells securities. • A new Consumer Financial Protection Bureau was established at the Fed to write rules concerning consumer protection from financial firms. The Structure of the Federal Reserve System

13.2 Learning Objective Explain the key issues involved in the Fed’s operations.

How the Fed Operates Handling External Pressure • The structure of the Fed is designed to operate largely independently of external pressures. • Not only is the Fed exempt from having to ask Congress for the funds to operate, but it is also a profitable organization. • Most of the Fed’s earnings come from interest on the securities it holds, interest on discount loans, and fees for check-clearing and other services. • But the Fed isn’t completely insulated from external pressure: • The president can exercise control over the membership and may appoint a new chairman every four years. • The U.S. Constitution does not specifically mandate a central bank, so Congress can even abolish it entirely. How the Fed Operates

Making the Connection Fedspeak vs. Transparency • Alan Greenspan, former chairman of the Federal Reserve Board, earned a reputation of “Fedspeak” as he often used ambiguous and vague language that confused securities traders. • By contrast, Ben Bernanke has been committed to greater transparency about the Fed’s monetary policy intentions. • Economists generally welcome more transparency, which can help households and firms make better economic decisions. • Critics argue that more transparency about policy commitment would give the Fed less leeway to respond to changes in the economy. • Still, some critics argue that the Fed is providing more information than anyone can interpret. How the Fed Operates

Examples of Conflict between the Fed and the Treasury • Elected officials lack formal control of monetary policy, which has occasionally resulted in conflicts between the Fed and the president. • During World War II, the Roosevelt administration increased its control over the Fed. The Fed agreed to hold interest rates on Treasury securities at low levels in order to help finance wartime budget deficits,. • When the war ended in 1945, the Treasury wanted to continue this policy, but the Fed didn’t agree for fear of inflation. • On March 4, 1951, the federal government formally abandoned the wartime policy of fixing the interest rates on Treasury securities with the Treasury–Federal Reserve Accord. • The Federal Reserve Accord was important in reestablishing the ability of the Fed to operate independently of the Treasury. How the Fed Operates

President Ronald Reagan and Fed Chairman Paul Volcker argued over who was at fault for the economic recession of the early 1980s. • Similar conflicts occurred during the administrations of George H. W. Bush and Bill Clinton, with the Treasury frequently pushing for lower short-term interest rates than the Fed considered advisable. • During the financial crisis of 2007–2009, the Fed worked closely with the Treasury. If such close collaboration were to continue, it would raise the question of whether the Fed would be able to pursue policies independently. • A proposal in early 2010 that the U.S. president appoint the presidents of the District Banks raised further concerns about Fed independence. • The provisions of the Dodd-Frank Act did little to undermine Fed independence. How the Fed Operates

Factors That Motivate the Fed The Public Interest View Public interest viewis a theory of central bank decision making that holds that officials act in the best interest of the public. The Fed seeks to achieve economic goals that are in the public interest (e.g., price stability, high employment and economic growth). Does the evidence support the public interest view of the Fed? Some economists argue that it doesn’t appear to with regard to price stability (e.g., persistent inflation since World War II). Other economists argue otherwise. There are similar debates over the Fed’s contributions to the stability of other economic indicators. How the Fed Operates

The Principal–Agent View Principal–agent view is a theory of central bank decision making that holds that officials maximize their personal well-being rather than that of the general public. • This view predicts that the Fed acts to increase its power, influence, and prestige as an organization, subject to constraints placed by principals (the president and Congress). • The principal–agent view also suggests that the Fed would fight to maintain its autonomy. Indeed the Fed has frequently resisted congressional attempts to control its budget. • The Fed successfully lobbied Congress to strip most of the provisions in the Dodd-Frank Act that would have reduced its independence. How the Fed Operates

According to the principal–agent view, the Fed could manage monetary policy to assist the reelection efforts of presidential incumbents who are unlikely to limit its power. • The result would be a political business cycle: The Fed would try to lower interest rates to stimulate economic activity before an election to earn favor with the incumbent party running for reelection. • The facts for the United States don’t support the political business cycle theory, but the president’s desires may subtly influence Fed policy. • One study found a close correlation between changes in monetary policy and signals from the administration that they desired a policy change. How the Fed Operates

Fed Independence Arguments for Fed Independence • The main argument for Fed independence is that monetary policy is too important and technical to be determined by politicians. • Because of the frequency of elections, politicians may be shortsighted, concerned with short-term benefits without regard for potential long-term costs. • The public may well prefer that the experts at the Fed, rather than politicians, make monetary policy decisions. • Another argument for Fed independence is that complete control of the Fed by elected officials increases the influence of political business cycles on the money supply. How the Fed Operates

Arguments against Fed Independence • The importance of monetary policy for the economy is also the main argument against central bank independence. • In a democracy, elected officials should make public policy. The public could hold elected officials responsible for perceived monetary policy problems. • If the central bank was controlled by elected officials, monetary policy could be coordinated and integrated with government taxing and spending policies. • Some critics note that the Fed failed to assist the banking system during the economic contraction of the early 1930s. Also, Fed policies were too inflationary in the 1960s and 1970s. • Some analysts believe that the Fed ignored the housing market bubble in the early 2000s and then moved too slowly to contain the effects of the bubble burst in 2006. How the Fed Operates

Concluding Remarks • There is no universal agreement on the merits of Fed independence. • Debates focus on limiting Fed independence, not eliminating its formal independence entirely. • The debate over the Dodd-Frank Act gave critics the opportunity to propose changes to the existing laws, but relatively minor changes were passed by Congress in the end. How the Fed Operates

Making the Connection End the Fed? • The U.S. Constitution does not explicitly give the federal government the authority to establish a central bank. • Opponents of the First and Second Banks saw them as a means of unconstitutionally exerting federal power over the states. • The standard argument in favor of the constitutionality of the Fed is that Article 1, Section 8 of the U.S. Constitution states that Congress has the power “To coin money [and] regulate the value thereof. . .” Congress delegated this power to the Federal Reserve under the Federal Reserve Act. • Modern arguments against the Fed have been mostly based on whether an independent central bank is the best means of carrying out monetary policy.. • Given the Fed’s power and the fact that its officials are unelected, its role will remain a subject of debate among economists and policymakers. How the Fed Operates

13.3 Learning Objective Discuss the issues involved with central bank independence outside the United States.

Central Bank Independence Outside the United States • The degree of central bank independence varies greatly from country to country. • In the United States, board members serve longer terms than in other countries, implying greater independence. In other countries, the head of the central bank serves a longer term, implying somewhat less political control. • An independent central bank is free to pursue its goals without direct interference from government officials and legislators. • An independent central bank can more freely focus on keeping inflation low. • The European Central Bank is, in principle, extremely independent, and the Bank of Japan and the Bank of England traditionally have been less independent. • By the late 1990s, both had become more independent and more focused on price stability. Central Bank Independence outside the United States

The Bank of England, founded in 1694 and one of the world’s oldest central banks, obtained the power to set interest rates independently in 1997. • The Bank of Japan Law, in force since April 1998, gives the Policy Board more autonomy to pursue price stability. • The Bank of Canada has an inflation target as a goal. While the government has the final responsibility for monetary policy, the Bank of Canada has generally controlled it. • The push for central bank independence to pursue a goal of low inflation has increased in recent years. • In most of the industrialized world, central bank independence from the political process is gaining ground as the way to organize monetary authorities. Central Bank Independence outside the United States

What conclusions should we draw from differences in central bank structure? • Many analysts believe that an independent central bank improves the economy’s performance by lowering inflation without raising output or employment fluctuations. • The most independent central banks had the lowest average rates of inflation during the 1970s and 1980s. • The central bank also must be able to set goals for which it can be held accountable. The leading example of such a goal is a target for inflation. • Central banks in Canada, Finland, New Zealand, Sweden, and the United Kingdom have official inflation targets, as does the European Central Bank. • The U.S. Fed has only an informal inflation target. Central Bank Independence outside the United States

The European Central Bank • The European Central Bank (ECB) is charged with conducting monetary policy for the 16 countries that participate in the European Monetary Union, and use the euro as their common currency. • The ECB’s organization is similar to that of the U.S. Fed. The ECB’s executive board has six members who work exclusively for the bank. • Board members are appointed by the heads of state and government, after consulting the European Parliament and the Governing Council of the ECB. • Executive board members serve nonrenewable eight-year terms. The governors of each of the member national central banks serve a term of at least five years. • The long terms board members and governors of are designed to increase the political independence of the ECB. Central Bank Independence outside the United States

In principle, the ECB has a high degree of overall independence, with a clear mandate to emphasize price stability. • Whether legal independence is enough to guarantee actual independence is another matter. National central banks have considerable power in the ECB. • The governors of the European System of Central Banks (ESCB) hold a majority of votes in the ECB’s governing council. • While the ECB statute emphasizes price stability, countries have argued over the merits of monetary policy actions. This conflict became evident during the financial crisis of 2007–2009. • Countries such as Greece, Spain, and Ireland urged that the ECB follow a more expansionary policy, while countries such as Germany that had fared better were reluctant to see the ECB abandon its inflation target. Central Bank Independence outside the United States

The European Central Bank and the 2010 Sovereign Debt Crisis • The 2007-2009 financial crisis affected the countries of the European Union, but the individual countries were not able to pursue independent policies in response. • During the crisis, these countries also suffered from large government budget deficits. To finance the deficits, they issued bonds (sovereign debt). • A sovereign debt crisis ensued when the debt issued by Greece, Ireland, Spain, and Portugal came into question. • On May 10, 2010, the ECB intervened by buying bonds. ECB President Jean-Claude Trichet argued that the intervention was necessary to ensure that the affected governments would still be able to raise funds and to protect the solvency of European banks. Central Bank Independence outside the United States

Answering the Key Question At the beginning of this chapter, we asked the question: “Should Congress and the president be given greater authority over the Federal Reserve?” In 1913, the Federal Reserve Act placed the secretary of the Treasury and the comptroller of the currency on the Federal Reserve Board. In 1935, Congress removed these officials from the board to increase the Fed’s independence. In 2010, Congress gave serious consideration to allowing the president to appoint the presidents of reserve banks, but this proposal was dropped from the final version of the Dodd-Frank Act. Economists and policymakers will continue to debate the merits of the Fed’s independence.

LEARNING OBJECTIVES