The Organization of The Fed and other Central Banks

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The Organization of The Fed and other Central
Banks
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A Brief History of Central Banks

• A Central Bank is an entity responsible for
  overseeing a nations banking system, acting as a
  lender of last resort, conducting monetary
  policy, and maintaining currency stability.
• The two oldest Central Banks are the Swedish
  Riksbank (1668) and the Bank of England (1694),
  though elements of Central Banking have been
  around since the introduction of fiat money by
  the Mongols in the 13th century.
• The Central Bank in the U.S., the Federal Reserve
  System, was not created until 1913
• Fear of centralized power along with a distrust
  of moneyed interests halted earlier attempts at
  creating a central bank
• A series of bank failures, culminating in panic
  of 1907 overcame these fears and paved the way
  for the Fed.
• To limit the centralization of power or influence
  by any one group, the Fed was subjected to checks
  and balances among private vs. public interests
  as well as national vs. regional

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Checks and Balances at the Fed
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The Federal Reserve System
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Federal Reserve Banks

• Quasi-public institution owned by private
  commercial banks in the district that are members
  of the Fed system
• Member banks purchase stock in their regional
  Federal Reserve Bank as a requirement of
  membership
• Member banks elect six directors (A and B) for
  each district three more (C) are appointed by
  the Board of Governors
• Three A directors are professional bankers
• Three B directors are prominent leaders from
  industry, labor, agriculture, or consumer sector
• Three C directors appointed by the Board of
  Governors are not allowed to be officers,
  employees, or stockholders of banks
• These nine directors at each bank then nominate a
  bank president to be confirmed by the Board of
  Governors
• By drawing directors from all sectors of the
  economy, no one industry can dominate the Feds
  actions

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The Functions of each Federal Reserve Bank

• Clear checks
• Issue new currency
• Withdraw damaged currency from circulation
• Manage discount loans to banks in each district
• Evaluate and advise on MA activity between banks
  in each district
• Connect the local business community and the
  Federal Reserve System
• Examine and advise local banks
• Collect data on local business conditions
• Conduct research into the conduct of monetary
  policy

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Monetary Policy and the Fed

• The directors of the Federal Reserve Banks
  establish the discount rate at which commercial
  banks borrow from the Fed.
• The Board of Governors have the right to review
  and determine this rate.
• The directors also decide which banks (both
  members and non-members) may borrow from the Fed
  at this discount rate
• The directors select one commercial banker from
  each district to sit on the Federal Advisory
  Council, which advises the Board of Governors
  about monetary policy
• Five of the bank presidents has a vote (along
  with the seven members of the Board of Governors)
  in the Federal Open Market Committee, the main
  arm of monetary policy
• All twelve bank presidents attend FOMC meetings,
  but only five vote.
• One vote always goes to the president of the New
  York Fed, while the other four rotate on an
  annual basis.

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The Members of the Fed

• All national commercial banks are required to be
  members of the Federal Reserve System
• A national bank operates in more than one state
  and is chartered by the Office of the Comptroller
  of the Currency.
• Membership entails purchasing stock in the
  commercial banks regional Federal Reserve Bank
• This stock cannot be traded or sold and pays a
  fixed 6 annual dividend.
• State-chartered banks can be members of the Fed,
  but are not required to do so.
• In the past, many state-chartered banks preferred
  not to become Fed members since they didnt want
  to keep reserves as deposits at the Fed (where
  they earned no interest)
• The Depository Institutions Deregulation and
  Monetary Control Act of 1980 required all
  commercial banks (members and non-members alike)
  to abide by the same reserve requirements.
• The majority of banks in the US are not members
  of the Fed, but majority of assets are controlled
  by members.

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Members and Non-Members of the Fed
State Bank (Non-Member)
National Bank
State Bank (Member)
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The Board of Governors

• Seven of the twelve votes on the FOMC go to the
  Board of Governors of the Federal Reserve System
• Each governor is appointed by the US President
  and confirmed by the US Senate to a single
  (non-renewable) 14 year term
• The seven governors must come from different
  districts to prevent regional dominance
• The Chairman of the Board of Governors is
  selected from this group and subject to
  reappointment every four years by the U.S.
  President.
• The Board has the most policy control in the Fed
  as it has
• A voting majority in the FOMC
• Sets reserve requirements within legislative
  limits
• Effectively controls the discount rate with its
  mandate to review and determine the rate set by
  the 12 Regional Banks.

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The FOMC

• When the media reports that the Fed met to lower
  interest rates, what they are really talking
  about is the FOMC
• The FOMC meets eight times per year (every six
  weeks) on a Tuesday.
• The FOMC is made up of the seven-member Board of
  Governors and five Regional Bank presidents (one
  of whom is always the president of the NY Fed)
• The other seven Bank presidents attend and
  participate in discussions, but do not vote.
• The FOMC meetings set a Federal Funds Rate that
  will be targeted through the Open Market
  Operations of buying and selling treasury bonds
  from/to the public.

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The FOMC

• At each FOMC meeting, three important reports are
  discussed
• The Green Book presents forecasts by the Fed
  research staff on the state of the economy over
  the next two years
• The Blue Book presents a favored monetary
  policy objective as well as three alternative
  policies to be considered.
• The Beige Book presents surveys and reports on
  the state of the economy in each of the twelve
  districts.
• Upon voting (generally in agreement with the
  Chairman), a public announcement is made about
  the outcome of the meeting as well as the
  economic trends prompting any policy changes
• The public announcement is a new development
  since 1994 and represents a growing trend toward
  transparency.
• The Chairman has a very powerful position within
  the FOMC (and by extension, the FED)
• Spokesperson for the Fed in talks with Congress
  and the US President
• Sets the agenda for meetings
• Speaks and votes first about monetary policy
• Supervises the professional economists from whose
  ranks the Board of Governors is most frequently
  selected.

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The European Central Bank

• For much of the post-WWII period, the Fed was the
  most important central bank in the world.
• This hegemony has been challenged since 1999 with
  the creation of the European Central Bank (ECB)
  and European System of Central Banks (ESCB)
• Following the mandates laid out in the Maastricht
  Treaty of 1992, eleven countries adopted a single
  currency (the euro) and ceded control of monetary
  policy to the ECB in January 1999.
• There are now fifteen countries using the euro,
  with more slated to join over the next decade.
• Each countrys central bank stayed in business,
  but now operates much like the Regional Reserve
  Banks in the US do.
• Monetary Policy is established at the ECB, by the
  Governing Council
• The Executive Board consists of the President and
  Vice President of the ECB along with four other
  members appointed to eight year non-renewable
  terms
• The fifteen presidents of the National Central
  Banks

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Central Bank Independence

• Consider three measures of Central Bank
  Independence
• Instrument independence ? the central bank is
  free to set any monetary policy
  instrument/variable
• Goal independence ? the central bank is free to
  set its own goals for monetary policy
• Political independence ? the central bank is able
  to conduct monetary policy without legislative
  influence
• Both the Fed and the ECB are considered to be
  very independent central banks
• The ECB has less goal independence as it has a
  mandate to promote price stability (2 inflation
  target recently)
• However, changes to the ECB cannot be made
  without a unanimous change to the Maastricht
  Treaty (by 15 countries!)
• Changes to the Fed may be made by a simple act of
  Congress.
• Political independence is built into the
  structure of these organizations
• Long and non-renewable terms
• Financed out of their own revenues rather than by
  legislative approval

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Should central banks be independent of political
influence?

• The strongest argument for independence is that
  an independent central bank is insulated from the
  political pressures of re-election
• Fiscal policy tends to follow a political
  business cycle inflationary during an election
  year, contractionary afterwards.
• If central banks were subject to political
  approval, monetary policy would also follow this
  volatile pattern
• Another argument in favor of central bank
  independence is that elected politicians do not
  have the technical savvy to conduct monetary
  policy
• Proponents of this view contrast the efficiency
  of a Federal Reserve run by bureaucrats with the
  bloated Federal budget (often in deficit) run by
  politicians
• If the central bank was beholden to political
  interests, the federal government could amass
  large budget deficits then turn to the Fed to pay
  off its debts (essentially printing up more money
  for the government to pay off its debts)
• Every time this has happened in history, massive
  inflation and financial crises have been the
  result.

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Should central banks be independent of political
influence?

• Is it democratic to have monetary policy for the
  entire nation in the hands of an elite group
  responsible to no one?
• If the Fed performs badly, there are few ways to
  replace its members (unlike Congress where the
  people can vote out underperforming legislators)
• If policy is best conducted by technically savvy
  elites, then why arent all military decisions
  made by the Joint Chiefs of Staff, all tax policy
  decisions made by the IRS, all environmental
  regulations made by the EPA, etc.?
• This criticism gains credence when you consider
  that the Fed has been a poor steward of the
  economy at times (failing to act early enough
  during the Great Depression, inflating the
  economy during the 1960s.)
• Close coordination between monetary and fiscal
  policy would achieve the most effective results.
  The best way to coordinate both types of policies
  would be to have them controlled by the same
  group.

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Should central banks be independent of political
influence?

• The empirical evidence on central bank
  independence is mixed
• Some studies find evidence that the countries
  with the lowest inflation rates are the most
  independent
• Other studies argue that while this is true, it
  is low inflation rates that are causing central
  banks to become independent