The Structure of the Federal Reserve

1. The Structure ofthe Federal Reserve Chapters 15

2. Overview • Origins of the U.S. Federal Reserve System • Formal Structure • Evolved Structure • Independence of the Fed • International Central Banking • Motivation of Central Bankers

3. Central Banks • Affect • Interest rate (federal funds rate) • Money Supply • Amount of Credit • Influence • Financial Markets • Economic Output • Inflation • International Trade

4. Origins • Historic fear in U.S. of centralized power • Rural, frontier, farmer interests • Feared loss of control to places far and away • Big city, moneyed, businessmen interests • Feared too much government involvement • Private or public central bank? • Resulted in formal check and balance system

5. Origins • No lender of last resort • Bank panics common every 20 years • Bank panic of 1907 • Stock market fell 50% • Wave of bank runs across the country after large speculative loans bust (on failed hostile buyout) • J.P. Morgan (private) stepped in to avert crisis: extra credit lines, bought out plummeting stocks, redirected money • By 1913, Fed. Reserve Act finally had enough support

6. Formal Structure of the Fed • 12 regional federal reserve banks • 4000 member commercial banks • Board of Govenors • Federal Open Market Committee (FOMC) • FOMC Meeting Schedule

7. Regional Fed Banks • 12 regional banks • NY Fed bank has 25% of Fed assets (SF and Chicago have another 25%) • Owned by member banks in area • Buy stock in their region’s bank • Elect 6 of 9 directors • 3 bankers • 3 from business, labor, agriculture • Max limit of 6% on Fed stock • Other 3 appointed by Fed Res. Board • Directors Elect President

8. Regional Fed Banks • Major Administrative Functions • Issue/Replace Currency • Clear checks • Regulate holding companies (McFadden) • Oversee state banks in FR system • Approve mergers and acquisitions • Help formulate monetary policy • “Establish” discount rate • Decide who gets discount loans • Sit on national Fed. Advisory Council to “advise” • 5 of 12 votes on FOMC

9. “The New York Special” • Region has the largest banks • Does all open market operations • Houses foreign exchange desk • Member of the Bank of International Settlements • President of this regional bank is ALWAYS on the FOMC

10. Member Banks • 4000 national and state members • National banks must join, state banks option • Between one-third and one-half have belonged since 1947 • Banks that don’t join can hold reserves as securities • Reserve ratio expensive • Fed lost control of MS because of this • DIDMCA: all depository institutions must keep reserves with Fed (get access to discount window and check clearing services) • Fed/Non-fed distinction diminished

11. Board of Governors • Head of Fed Reserve System Nationally • 7 members • 14 year terms, non-renewable • Chairman appointed by president • Administrative Duties • Approve salaries, budgets of regional banks • Regulate holding companies, foreign banks • Approve mergers and state banks (jointly w/Reg. banks)

12. Board of Governors • Monetary Policy • 7 of 12 FOMC seats • Set reserve requirements • APPROVE discount rates set by regional banks • Advise politicians • President • Congress • Foreign Gov’t

13. Federal Open Market Committee • 12 members • 7 board of governor members • 5 regional president members rotating • Meets every six weeks • Decisions about how many bonds to buy/sell and thereby change money supply • Also generally discuss discount rate, reserve ration

14. Typical FOMC Meeting • Green book: where economy is headed • Blue book • Projections for monetary supply • Discuss three alt. recommendations for MS • Open market • Discount Rate • Reserve Ratio • Beige Book • Regional banks, report on regional state of economy

15. Meeting Implications • Chairman (Ben Bernanke) presents his views on economy • Vote taken on EXACT directions to open market desk at NY regional bank • Announce changes in federal funds rate, discount rates • New since 1994 • Tuesday, March 18th: drop in federal funds rate of 0.75%!

16. Informal Structure of the Fed • 1913 act SUPPOSED to create highly decentralized federal reserve system • 12 separate central banks not responsible for health of economy • No control of monetary supply (except discount loans • No control of interest rate (except discount rate)

17. Informal Structure • Depression reforms • Control of money supply (1933) • Control of reserve ratio (1935) • Board of governors has 7 of 12 votes on FOMC • BOG also strongly influences regional appointees • Member banks have very little power, pretty much branches of central bank in Wash. • Chairman doesn’t formally have control, but… • Sets agenda for FOMC meetings • Representative to president, Congress • Controls staff who set green/blue books • Most powerful office in America??

18. Independence of the Fed • Remarkably independent • 14 year, nonrenewable terms • Don’t have to go to Congress for budget approval • Income from loans, securities • Cannot be audited by Federal Government • But… • Congress can change power in long run • President appoints members, relationship with chairman • Alan Greenspan though…

19. Should the Fed be Independent? • For independence • Political bias (willing to risk long term inflation) • Political “business cycle” • President can’t finance federal deficit with purchases of bonds • Empirical evidence: independent central banks have less inflation • Politicians like independence! • Don’t have to make hard decisions • Not always economic experts • Candidacy doesn’t depend as much on monetary policy ups and downs

20. Against Independence • Undemocratic, elitist, technocrats • Not accountable to anyone • Moral hazard, principle-agent • President and Congress are held accountable, so they should have ultimate authority • Coordination of monetary and fiscal policy harder • Fed makes mistakes too, and less checks and balances leave less of safety net

21. Foreign Central Banks • European Central Bank (EU, 1999) • Independent • Similar to U.S., each country has regional bank • Japan (Nippon Ginko, 1882) • Legally dependent • Answers to ministry of finance • Traditionally allowed independence • Canada (1934) • joint-control, almost independent • Bank of England (1694) • Very dependent (to UK gov, not EU) • Can only recommend policy • 1997: can set interest rates, but must be approved

22. Motivations of Central Bankers • Public Interest View • Bank has society’s best interests in mind, or at least the financial industry’s best interests • Civil Servant Perspective • Theory of Bureaucratic Behavior • Maximize the agency’s own welfare • Power corrupts, self-survival • Implications • Push for autonomy • Avoid controversial decisions (current events?)