FNCE 4070 Financial Markets and Institutions

1. FNCE 4070Financial Markets andInstitutions Lecture 7 Central Banking and the Conduct of Monetary Policy

2. What are These Central Banks and Who are These Central Bankers?

3. Why Study Central Banking? • Answer: Central bank actions have significant impacts on financial markets and specifically on: • (1) interest rates (the cost of borrowing and the return on investing). • (2) financial asset prices (stocks, bonds, foreign exchange) • Thus we need to know something about central banks: • How do central banks operate in financial markets? • How can we monitor the potential for changes in central bank actions? • Understanding these issues will add to our understanding of (1) and (2) above.

4. Who Runs a Country’s Central Bank? • Central Banks may be either: • (1) government owned and government controlled or • (2) run under regulations that are specifically created to prevent extensive government interference. • In most countries -- especially in the developing world -- the central bank is owned and controlled by the national government and, thus, has the potential for a minimal degree of autonomy from that government. • This situation, unfortunately, allows for the possibility of government interference in monetary policy. • As one example, the Central Bank of China, the People's Bank of China (PBOC) enjoys little operational independence. • Unlike Western central banks, the PBOC does not have the final word on adjusting interest rates or the value of the yuan. The basic course of monetary and currency policy is set by the State Council, China's cabinet, or by the Communist Party's ruling Politburo.

5. Central Banks in Major Countries • In the major countries of the world, however, central banks generally operate “independent” of their respective governments. Some of these banks are owned by their governments while others are not. • The Bank of England was nationalized in 1946; however in 1997 it became an “independent” public organization, still wholly owned by the Government, but with “independence” in setting monetary policy to achieve government mandated inflation target. • The Federal Reserve, on the other hand, is “owned” by the 12 district banks and it is considered an independent central bank because: • Its decisions do not have to be ratified by the President or anyone else in the executive or legislative branch of government, • It does not receive funding appropriated by Congress, and • The terms of the members of the Board of Governors span multiple presidential and congressional terms.

6. Reducing Government Control of Central Banks • Removing government control is designed to prevent political interference in the monetary policy process. • In reality, however, the degree of true independence, or separation from government involvement, varies even among these countries. • Some governments (e.g., the U.K., Australia, and Canada) are actively involved in setting specific inflation targets for their central banks. • Others such as the ECB’s operate within an inflation target as implied in its original charter. • The Federal Reserve is probably an example of a central bank with the greatest separation from government involvement.

7. Major Central Banks Independence • Central Bank (Date Founded)Date of Independence* • Federal Reserve (1913): 1913** • Bank of England (1694): 1997*** • Bank of Japan (1882): 1998**** • European Central Bank (1999): 1999***** • *Recognized date of “separation from government influence.” • **Granted in the 1913 Federal Reserve Act. • ***Following the election of the new Labor Government in May 1997. • ****Under revisions to the Bank of Japan Law • *****As noted in the Maastricht Treaty (1993) and specified in the Bank’s charter.

8. Should Central Banks be Independent? • Over the years, there has been growing debate as to the most efficient and effective arrangement for central banks. • Case for Central Bank Independence: • Independent Central Banks are more likely to have longer run objectives while politicians may have shorter term objectives. • Independence minimizes a “political” (i.e., election induced) business cycle. • A 2005 study suggested that political business cycles have been concentrated in the Latin America region. • Empirical work suggests that countries with the most independent central banks do the best job of controlling inflation and achieving economic growth (see slides which review this evidence). • Case against Central Bank Independence • Central Bank should be accountable (at least in terms of their goals) to their general populations (and perhaps less so in terms of their policies to achieve goals). • Hinders coordination of monetary and fiscal policy.

9. How Independent are Central Banks Today? • Some central banks which we characterized as “independent” have their inflation goals set by their national governments, but are given freedom with regard to the use of policy instruments to achieve those goals. • Bank of England: “The Bank’s monetary policy objective is to deliver price stability. Price stability is defined by the Government’s inflation target of 2%. The 1998 Bank of England Act made the Bank independent to set interest rates.” (Bank web-site). • Other examples: Brazil, China, Mexico

10. Variations on Inflation Target Process • Switzerland: the central bank has authority to set its inflation target (currently at no more than 2% a year for the medium to long term). • ECB governing council sets its own inflation target (currently 2%) consistent with the 1992 Maastricht Treaty’s stated goal of “price stability.” • Canada and New Zealand’s inflation targets are determined jointly by their respective governments and their central banks. • Both the U.S. and Japan, where neither the Fed nor the BOJ has specific mandated government (inflation) goals.

11. Central Bank Independence and Inflation, 1955-1988

12. Central Bank Independence and Inflation, 1973-1988

13. Central Bank Independence and Economic Growth, 1973-1988

14. Visualizing the Path of Central Bank Monetary Policy • Monetary Policy Tools (Policy Instruments) • (1) Open market operations (buying and selling debt) • (2) Discount window (borrowing) facilities • (3) Reserve requirement adjustments • (4) Intervention in foreign exchange markets • Operational Targets (Targets of Policy Actions) • Monetary aggregates (money supply measures) • Financial market variables (short interest rates, exchange rates) • Macroeconomic Target (Ultimate Goals of Policy) • Inflation • Economic growth • Employment • External trade

15. Question: What is the Most Commonly Used of Policy for the Fed? • Monetary Policy Tools (Policy Instruments)? • (1) Open market operations • (2) Discount window (borrowing) facilities • (3) Reserve requirement adjustments • (4) Intervention in foreign exchange markets • Operational Targets (Targets of Policy Actions) • Monetary aggregates (money supply measures) • Financial market variables (short interest rates, exchange rates) • Macroeconomic Target (Ultimate Goals of Policy) • Inflation • Economic growth • Employment • External trade

16. Historical Use of Fed Policy Instruments • 1913 Act: Major policy instrument was the discount facility and the discount rate (“rediscounting of commercial paper”). • Federal Reserve Act of 1913 actually had no provision for changes in reserve requirements and open market operations as a policy tool were not yet “discovered.” • When discount loans (which were a source of income for the Fed) fell in 1920, the fed started to purchase seasoned securities for income and as they did so they quickly realized that these “open market operations” were having a impact on bank reserves. • Thus, as a result, open market operations evolved into the major Fed instrument from this point on.

17. Open Market Operations • (1) Open market operations: Purchases and sales of U.S. Treasury and federal agency as specified by the Federal Open Market Committee (FOMC). • A short term objective is specified in terms of a desired interest rate (federal funds rate) and is conveyed to the Federal Reserve Bank of New York for implementation. • Since 1995 the Fed has specified an explicit target level for the federal funds rate. • For specific targets since 1995, see: http://www.federalreserve.gov/fomc/fundsrate.htm • The FOMC has regular meeting scheduled approximately every 6 weeks (8 times a year), although it can call an emergency meeting anytime. • For scheduled meeting and minutes of meetings see: http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm

18. Discount Facility • (2) The discount rate: The interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank. • Federal Reserve Banks offer three discount window programs to depository institutions: • (1) primary credit, i.e., overnight, (current rate 0.75%) • (2) secondary credit (to meet severe short term financial difficulties (current rate 1.25%), and • (3) seasonal credit, i.e., to smaller institutions in agricultural or seasonal resort areas (current rate 0.20%) • All discount window loans must be fully secured (usually with Treasury securities). • The term “discount rate” is normally applied to the rate on primary credit loans. • For current and historical discount rates see: http://www.frbdiscountwindow.org/index.cfm

19. Relationship of Discount Rate to Fed Funds Rate • Historically, the discount rate was set below the federal funds rate. • To discourage banks from borrowing at the discount window and lending it out at a profit in the fed funds market, the Fed required a bank to prove it that a discount loan was its last option for securing needed funds. • In 2003, however, the Fed introduced a new policy by which the discount rate is now set above the fed funds rate. • Since 2003, the discount rate has averaged 85 basis points above the effective fed funds rate. • See exhibits on next slide.

20. Fed Funds Rate and Discount Rate 1995 - 2002 2003 - Present

21. Reserve Requirements • (3) Reserve requirements: The amount of funds (reserves) that a depository institution must hold in reserve against its specified deposit liabilities. • Reserves can be held the form of vault cash or deposits with Federal Reserve Banks. • Reserves requirements are set against transaction accounts (e.g., demand deposits, NOW accounts, etc), time deposits, and eurocurrency deposits. • Under the Monetary Control Act of 1980, the Fed can vary reserve requirement up to 14% on transaction accounts and up to 9% on all other deposits. • This act also applies these reserve requirements to all commercial banks, regardless of Fed membership. (See next slide) • For historical and current reserve requirements see: http://www.federalreserve.gov/monetarypolicy/reservereq.htm

22. Monetary Control Act (MCA) of 1980 • Before the passage of the MCA in 1980, only commercial banks that were members of the Federal Reserve System had to meet the Fed's reserve requirements. • State-chartered commercial banks that were not Federal Reserve members had to meet their respective state's reserve requirements, which typically were lower. • As a result, many commercial banks were dropping their Federal Reserve membership in favor of state charters. • And, as banks did so, Federal Reserve member bank transaction deposits fell from nearly 85% of total U.S. transaction deposits in the late 1950s to 65% by the late 1970s. • The MCA resolved this problem by authorizing the Fed to set reserve requirements for all depository institutions, regardless of Fed membership status.

23. Limited Use of Reserve Requirements as a Monetary Policy Tool • Since 1980, there have been only a handful of policy-related reserve requirement changes in the United States. As two examples: • In December 1990, the Fed cut the requirement on time deposits and on Eurocurrency deposits from 3% to 0%. • The Fed suggested that the cut would reduce banks' costs, "providing added incentive to lend to creditworthy borrowers.“ • In April 1992, the Fed cut the requirement on transaction deposits from 12% to 10%. • The Fed suggested that this cut would put banks "in a better position to extend credit."

24. Question: What Operational Target Does the Fed Use? • Monetary Policy Tools (Policy Instruments) • Open market operations • Operational Targets (Targets of Policy Actions)? • Monetary aggregates (money supply measures) • Financial market variables (short interest rates, exchange rates) • Macroeconomic Target (Ultimate Goals of Policy) • Inflation • Economic growth • Employment • External trade

25. Historical Use of Operational Targets by the Federal Reserve • Interest Rate Targets: • In the years immediately after WW II, the Federal Reserve agreed to “peg” interest rates at very low levels (3/8% on Treasury bills and 2 ½% on Treasury bonds). • Fed agreed to this interest rate target as a way of holding down the Treasury’s war financing costs (see next slide) • In 1951, an agreement was reached between the Treasury and the Fed agreed that the Fed would no longer peg Treasury interest rates (agreement called the “The Accord”) . • In the 1950 and 1960s, the Federal Reserve decided to target money market conditions, and specifically short term interest rates.

26. Short Term Interest Rates After WWII

27. Historical Use of Operational Targets by the Federal Reserve • Recall that in the 1970s, the U.S (as well as other industrial countries) experienced very high inflation rates. • During this time, under increasing criticism from “monetarists” that central banks were unable control inflationary pressures, the shift was from interest rate targets to targeting of monetary aggregates, specifically various money supply measures (M1, M2, etc). • Milton Friedman (1968): “Inflation is always and everywhere a monetary phenomenon.” • By the end of the 1970s, most major central banks had dropped interest rate targets and adopted some form of monetary aggregate targeting; • Bank of England in 1973 • Bundesbank (Germany) in 1975 • Bank of Japan in 1978 • Federal Reserve October 6, 1979.

28. Short History of Money Supply Targeting • The 1978 Humphrey-Hawkins Act mandated that the Fed set annual targets for money supply and that the Fed Chairman report to Congress twice each year regarding these targets. • However, a monetary target was a appropriate only so long as its velocity (the rate of turnover of a dollar of the money supply) was stable over the long term. • Unfortunately, the long term stability of money velocity, which was at the core of monetarism, disappeared beginning in the late 1980s. • In addition, there was concern that in targeting the money supply, central banks were losing control over interest rates and these rates were becoming more volatile.

29. Velocity of Money

30. Volatility of Interest Rates in the 1980s

31. Return to Interest Rate Targets • By the 1980s, central bank concern about the changing velocity of money combined with the wide swings in interest rates which had been occurring, resulted in the “de-emphasis” this monetary aggregate approach. • Thus by the 1990s, central banks had shifted their operational target focus back to short term interest rates. • In July 1993, the Fed announced it was no longer using any monetary targets. • In the 1990s, most major central banks had abandoned monetary targets in favor of some short term interest rate as their operational target. Today’s rates are: • Fed Reserve: The fed funds rate (rate for reserves in the interbank market). • Bank of England: Official bank rate • European Central Bank: Main refinancing rate • Bank of Japan: Uncollateralized overnight call rate

32. Question: What is Fed’s Most Commonly Used Macroeconomic Target? • Monetary Policy Tool • Open market operations (Buying and selling Treasury securities) • Operational Target • Financial market variable (short term interest rates) • Macroeconomic Target? • Inflation target • Economic growth target • Unemployment rate target • Exchange rates target

33. Early U.S. Central Bank History • Except for two failed attempts (1791 and 1816), the U.S. operated without an effective central bank up until 1913. • Prior to 1913, there were frequent economic recessions and financial crises in the U.S. with the Bank Panic of 1907 finally convincing the government that a central bank was necessary. • On December 23, 1913, Congress passed and President Woodrow Wilson signed into law The Federal Reserve Act, establishing a central bank for the United States. • The Act was also called the Glass-Owen Act. • The 1913 Act was to “provide for establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of bankingin the United States, and for other purposes.” • Note: There were no explicit macro economic goals in the 1913 Act and no mention of open market operations.

34. U.S. Economic Performance During the Early Fed Years

35. Changing Goals of the Federal Reserve • In response to the unemployment crisis of the Great Depression, the U.S. Congress, in February 1946, passed the Full Employment Act: • “The Congress hereby declares that it is the continuing policy and responsibility of the Federal Government … to promote maximum employment, production and purchasing power.” • These new goals also become the goals of the central bank.

36. The 1970s -80s: A New Problem Inflation in Industrial Countries, % per year • Recall, in the 1970’s, global inflation became the major economic issue for industrial countries. • Two distinct inflation peaks: 1973/74 and 1980/81. • As a result, many central banks turned their attention to inflation and some to the use of inflation targets as a macro economic goal. • Begins with New Zealand adopting an inflation target of 0 to 2% in March 1980.

37. Adoption of Explicit Inflation Targets • Early Adopters (with original target): • New Zealand: March 1990 (set at 0 to 2%) • Canada: February 1991 (set at 1 to 3%) • United Kingdom: October 1992 (set at 2%) • Australia: January 1993 (set a 2 to 3%) • Sweden: January 1993 (set at 2%) • Finland: February 1993 (set at 2%) • Spain: January 1995 (set at 3.5 to 4%) • Later Adopters (with original target) • Euro-zone: Jan 1999 (set below, but close to, 2%) • Poland: January 1999 (8 to 8.5%) • Brazil: June 1999 (set at 8%) • South Africa: 2002 (set a 3 to 6%)

38. Initial Response of the U.S. to High Inflation U.S. Inflation In 1977, additional mandates for the Federal Reserve were introduced with Congressional amendments to the Federal Reserve Act: The 1977 amendments required the Board of Governors and the FOMC to "maintain the growth of 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 long-term interest rates.“ However, no explicit inflation targets were introduced at that time.

39. History of Macroeconomic Targets • From a practical standpoint there are any number of macroeconomic variable a central bank might target, including: • A unemployment rate (has been proposed for South Africa) • A real GDP growth rate • An exchange rate (Bretton Woods, 1944 – 1971; U.K.: October 1990 – September 1992; Hong Kong and Singapore today) • An inflation target • The use of exchange rate targets was popular among some central banks in the late 1980s/early 1990s. • Bank of England adopted an exchange rate target in 1990. • As noted earlier, in March 1990, the Central Bank of New Zealand was the first to adopt an inflation target. • Over the decade of the 1990s, a growing number of countries adopted inflation targets • From 4 countries in 1990 to 54 by 1998. • And in 2009 the U.S. followed with an announced “implied” inflation target of 2%

40. Case Study: Inflation Targeting in New Zealand Note: GST refers to Goods and Services Tax • New Zealand had informally “targeted” inflation at 0 to 2% beginning in 1988; although in 1990 it was formally introduced into law with the New Zealand Act of 1989.

41. Inflation Targeting Impact on Interest Rates: New Zealand

42. Final Issue: Central Bank Transparency • Transparency means that a central bank provides the general public and financial markets with relevant information in an open, clear and timely manner. • Transparency is potentially important because it reduces uncertainty about a central bank’s intention. • Helps the financial market establish “anchors” critical to their expectations. • Today, most central banks consider transparency as crucial to their success. • Monetary policy is assumed to be more effective when the central bank provides the public with guidance on its objectives, activities and outlook.

43. Central Bank Transparency Many Central Bank web sites are now in English: Visit: http://www.bis.org/cbanks.htm Many central bankers regularly talk to the “public.” Central Bank decisions and actions are published in a timely manner. Federal Reserve Bank: Has eight scheduled meetings per year. A press statement is released immediately following each meeting. http://www.federalreserve.gov/fomc/#calendars Bank of England Monetary Policy Committee meets the first Thursday of every month. The decisions on interest rates are announced at 12 noon immediately following the meeting. http://www.bankofengland.co.uk/monetarypolicy/decisions/decisions07.htm Governing Council of the ECB meets on the first Thursday of each month with the decision on the key ECB interest rates is issued at 1:45 p.m. C.E.T. At 2:30 p.m. C.E.T. , the President and the Vice-President of the ECB hold a press conference to discuss the decision. http://www.ecb.int/press/govcdec/mopo/2007/html/index.en.html Bank of Japan announce their interest rate decisions immediately following their meeting. http://www.boj.or.jp/en/mopo/mpmdeci/index.htm/

44. ECB and Bank of England Press Releases • ECB: http://www.ecb.int/press/html/index.en.html • ECB Follow-up (With Q and A) http://www.ecb.int/press/pressconf/2008/html/index.en.html • Bank of England: http://www.bankofengland.co.uk/publications/news/2008/index.htm

45. Measures of Central Bank Transparency

46. Links to World’s Major Central Banks United States: http://www.federalreserve.gov/ European Union: http://www.ecb.int/ Bank of England: http://www.bankofengland.co.uk/ Bank of Japan: http://www.boj.or.jp/en/index.htm

47. Other Useful Web Sites • Links to all the world’s Central Banks (note: 172 banks as of March 27, 2011) • http://www.bis.org/cbanks.htm • Federal Reserve statistical data • http://www.federalreserve.gov/releases/ • Economic time series, U.S. and some foreign (also allowing for graphing of data) • http://www.economagic.com/

48. Appendix 1: The Channel of Fed Policy The following is from the Federal Reserve web site and articulates in the Fed’s words the channel of monetary policy in the U.S. today

49. U.S. Monetary Policy Channel • According to the Federal Reserve: • “Using the three policy instruments, the Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and in this way alters the federal funds rate. • Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.” • http://www.federalreserve.gov/monetarypolicy/fomc.htm

50. Appendix 2: The Organizational Structure of the Federal Reserve