Transcript Document

Korean Monetary Policy and the Financial System
Spring 2012
Structure of Central Banks &
The Federal Reserve System
Boardroom
BOG
Washington, D.C.
"The job of the Federal Reserve is to take
away the punch bowl just when the party is
getting good.”
William McChesney Martin, Jr.
(Chairman of the Fed, 1951 - 1970 )
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A Brief History
• Americans’ fear of centralized power and distrust of
moneyed interests prevented emergence of central bank
until early 20th century.
• Without a lender of last resort, the US had repeated bank
panics in the 19th and early 20th centuries
• A severe financial panic in1907 led to recognition of
need for a central bank.
• Federal Reserve Act of 1913 established Federal Reserve
System with its 12 regionalized banks
• Creation of 12 regional Fed banks, instead of one
powerful central bank, reflects the American public's
historical hostility to large and powerful banking interests
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Formal Structure of the
Federal Reserve System (the Fed) at a Glance
Board of Governors
(BOG)
7 members including
the Chairman
12 Federal Reserve
Banks (FRBs)
Member Banks
Each with 9 directors
who appoint president
of the FRB
member
commercial banks
Federal Open Market
Committee (FOMC)
Federal Advisory Council
12 members (bankers)
7 Governors and 5 FRB
presidents
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Formal Structure & Allocation of Policy Tools
in the Fed
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Board of Governors
Often called the Federal Reserve Board, BOG is the
decision making center of the Fed
• Headquartered in Washington DC.
• Consists of 7 Governors including the Chairman
• Each governor is appointed by the President and
confirmed by the Senate for a nonrenewable 14-year term
☼ Terms expire every 2 years, so that President can appoint
2 of 7 members of BOG in a 4-year term unless there are deaths
or resignations.(staggered appointment system)
• The chairman and vice-chairman are also appointed by
the President with the consent of the Senate to serve a
4-year term, which is renewable.
☼ They can (but usually don’t) finish the remainder of their 14year terms as ordinary Board members when their terms of
office end.
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The length of the terms and the staggered appointments
process are intended to contribute to the insulation of the
Board -- and the Federal Reserve System -- from
political pressures to which it might otherwise be subject.
• Not more than one Governor can come from each
Federal Reserve District.
• Involved in making decisions regarding monetary policy.
 All seven Governors are voting members of the FOMC,
which controls the monetary base, and thereby exerts the
most powerful influence on money supply.
 Sets the reserve requirements
 Effectively controls the discount rate (the interest rate
charged on discount loans), i.e., it can approve or
disapprove the rate “set” by regional banks.
 Advises the US President on economic matters
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• The BOG also has other responsibilities. It supervises
banking industry and financial markets and help
formulate policies
 Sets margin requirements for stock purchases
(the fraction of the purchase price of the securities that has to be
paid for with cash rather than borrowed funds)
 Approves bank mergers and applications for new activities
 Specifies the permissible activities of bank holding companies
 Supervises the activities of foreign banks in the US
• Chairman of the BOG
 Dominant figure in formation and execution of monetary policy
 Most influential member of the FOMC
 Advises president, testifies before Congress, represents Fed
to the media.
 Widely regarded as the second most powerful man in the US
(some would put him first)
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Three Recent Fed Chairmen
Paul A. Volker (1979~83, 83~87)
• Appointed by President Carter, a Democrat,
in August,1979
• During 1979-80, inflation was both rapid
and strong with surging wage costs and
prices in the aftermath of the 2nd oil shock.
• Aggressively pursued a stringent monetary policy, slashing
the growth rate of money supply. As a result, short-term
interest rates jumped to over 20% and unemployment rate
climbed up, yet he remained unperturbed by the criticism
and pressure to ease up.
• The strategy of bringing inflation under control first despite
economic slowdown to pursue economic recovery later
worked; inflation rate dropped from 13.5% in 1981 to 3.2%
in 1983.
• Reappointed by President Reagan, a Republican, in 1983
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Alan Greenspan (1987~92, 92~96,
96~2000, 2000~2004, 2004~2006)
• Originally took office as Chairman and to
fill an unexpired term as a member of the
Board of Governors on August 11, 1987
(appointed by President Reagan)
• Reappointed by George H.W. Bush to the Board to a full
14-year term, which began on February 1, 1992 (and ran
until Jan. 31, 2006) and also as Chairman of the Board
• Reappointed as Chairman by Clinton in 1996 and 2000,
and by George W. Bush in 2004 to serve his 5th 4-year
term.
• On January 31, 2006, he left the Fed after serving as
Chairman for18 years and 6 months with the expiration
of his 14 year Board membership.
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• During his tenure, from early 1991 to early 2001, the
U.S. economy experienced the longest period of
expansion in its history, marked by uninterrupted high
growth with stable prices.
• Had to deal with many crisis situations including the
stock market crash of 1987, Asian financial crisis of
1997, collapse of LTCM in 1998, September 11 terrorist
attack of 2001, etc; Responding with eminent diagnosis
and prescriptions, he successfully mitigated the shocks
to the markets.
• Many think that he was good at leading the markets to
respond the way he wanted, thus keeping the risk under
control, by way of conveying his intended message to
the market using indirect and opaque words rather than
definitive and direct words and maintaining credibility
with the markets.
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▫ In December 2006, he put a restraint on imprudent
investment by warning about the overheating of the stock
market calling it ‘irrational exuberance’.
• When he responds to the inflationary pressure, he raised
the federal funds rate by a small margin many times.
• When responding to economic recession, he implemented
bold, preemptive rate cutes. In early to mid 2000’s,
however, his protracted low-interest rate policy coupled
with lax lending behavior of the banks caused mortgage
bubble, leading to overheating of the housing market (in
major large cities, in particular).
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• The environment marked by deregulation/self-regulation
during the years of real-estate bubble led to an explosive
growth of credit risk derivatives such as CDS(Credit
Default Swap). When housing market decline
accelerated, the values of these derivatives were wiped
out, leading to collapse of investment banks.
What unfolded subsequently was dramatic; stock market
crash, global financial crisis and worsening economic
downturn.
□ Since middle of 1990s, Greenspan strongly and consistently
made clear his opposition against regulation of financial
derivatives. The financial crisis of 2008 triggered a harsh
reappraisal of his performance as Fed chairman along with
the criticism that he failed to prevent banks from their
imprudent lending behavior.
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Federal Funds Rate
January 1992 – January 2012
7
6
5
4
3
2
1
0
92
94
96
98
00
02
04
06
08
10
12
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Case-Shiller Housing Price Index
January 1987 – December 2011
230
210
190
170
150
Composite Index (10 Cities)
130
Composite Index (20 Cities)
110
90
00
01
02
03
04
05
06
07
08
09
10
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Ben Bernanke
(February 2006 ~ present)
• Established a reputation for being an
expert in inflation theories, depression,
etc. while teaching at Princeton
University for 17 years.
• Served as Chairman of CEA (Council of Economic
Advisors) since June of 2005 until appointed as
Chairman of the Fed by George Bush
• Unlike Greenspan, uses clear and direct language
“Economics is a very difficult subject. I've compared
it to trying to learn how to repair a car when the
engine is running.” - Ben Bernanke 16
• Responded unhesitantly and aggressively to the financial
crisis that began to unfold with the deepening of housing
market decline that began in early 2007, a year after he
started his terms of office.
• Aggressively pursued financial bailout policies along with
Treasury Secretary Henry Paulson to prevent collapse of
the system when the financial crisis was intensifying with
a severity much like that of the Great Depression of the
30s.
□ Whatever the merits of saving A.I.G., many financial experts
agree that the Bush Administration’s policy of buying more time
for the financial industry to fix itself (at the Fed, this is known
as the “finger-in-the-dike strategy”) needs supplementing with a
direct attack on the slumping property market—the source of all
the losses. Bailing Out, John Cassidy, New Yorker
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Confessions of former and present Fed chairmen
• “A critical pillar to market competition and free
markets did break down. I still do not fully understand
why it happened.”
- Alan Greenspan
• “I and others were mistaken early on in saying that the
subprime crisis would be contained.”
- Ben Bernanke
• “The causal relationship between the housing problem
and the broad financial system was very complex and
difficult to predict.”
- Ben Bernanke
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Federal Reserve Banks
• The US is divided into 12 Federal Reserve districts, each
with a main Federal Reserve Bank and a number of
Federal Reserve Bank branches.
• The largest Fed Banks in terms of assets are: New York
(2nd district), Chicago (7th district), and San Francisco
(12th district).
• Each regional Fed bank is a legally separate quasi-public
institution. Why quasi-public?
 Owned (not by the government but) by the commercial
banks in its district -- called the member banks. These
private banks own shares in their Fed bank, which pays a
6% annual dividend.
 The Fed banks are non-profit and are legally required to turn
over 100% of their profits to the Treasury.
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• Each Federal Reserve Bank has 9 directors, classified into
three categories:
 3 Class A Directors = bankers, elected by member banks.
 3 Class B Directors = prominent business people, also
elected by member banks.
 3 Class C Directors = representatives of the non-bank public,
appointed by the Board of Governors.
• Each regional bank's board of directors appoints its
president.
• Monetary policy functions of the Fed Banks
 The directors of each bank recommend a setting for the
discount rate, which is then approved by the BOG.
 Make discount loans to depository institutions in their districts.
 At any given time, five Fed Bank presidents have a vote on
the Federal Open Market Committee.
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The directors of each bank select one banker from their
district to serve on the Federal Advisory Council
 NY fed president and four other rotating presidents have a
vote on the FOMC, directing open market operations
• Other functions performed by the Federal Reserve Banks:
 Clear checks
 Issue new currency
 Withdraw damaged currency from circulation and replace it
with new currency.
 Act as liaisons between local business communities and the
Federal Reserve System.
 Evaluate some bank merger applications
 Examine state member banks
 Collect data on local business conditions
 Use staff economists to undertake and publish research
related to the conduct of monetary policy.
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• Of the 12 regional Fed banks, Federal Reserve Bank of
New York is the largest and most important, reflecting the
role of New York as the financial center of the US and,
possibly, the world. The New York Fed
 houses the open market trading desk, which conducts open
market operations (buying and selling of securities so as to
influence the money supply and interest rates) at the request
of the FOMC
 houses the foreign exchange trading desk, which conducts
foreign exchange interventions on behalf of the Fed and the
US Treasury to influence the dollar's exchange rate
 Is the only Fed bank that has membership in the Bank for
International Settlements (BIS)
 Is responsible for examinations of bank holding companies
and state-chartered banks in its district, some of which are
the largest in the US.
 Partially because of these reasons, the President of the New
York Fed is permanently on the Board of Governors
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Federal Reserve Districts
The Federal Reserve System's centralized component, the Board of
Governors, is located in Washington, D.C. Its decentralized
components, Reserve banks, are scattered throughout the country
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Member Banks
• All national banks are required to be members of the
Federal Reserve System
• Commercial banks chartered by the states are not
required to be members but can choose to join.
• Prior to 1980 only member banks were required to keep
reserves as deposits at the Fed Banks. With high interest
rates of 1980s, membership fell due to rising cost of
membership.
• This weakened the ability of the Fed to control the money
supply, so 1980 “Depository Institutions Deregulation and
Monetary Control Act” made all banks subject to same
requirements to keep deposits at the Fed (also all banks
were given access to discount window)
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FOMC (Federal Open Market Committee)
The committee that makes decisions regarding the conduct
of open market operations (OMO) by a majority vote
• Policy-making arm of the Fed
• Meets 8 times (approximately every six weeks) per year,
assesses the condition of the economy and votes on
monetary policy in the coming weeks
▶ 2012 (Jan 24-25, Mar 13, April 24-25, June 19-20, July 31, Sept 12,
Oct. 23-24, Dec 11)
http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm
• Consists of 12 members which include
▶ all 7 members of the Board of Governors
▶ the president of the New York Fed
▶ and 4 of the other Reserve Bank presidents
who serve one-year terms on a rotating basis
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• The other seven Reserve Bank presidents who do not
vote still attend meetings and participate in debates
and discussions.
• The Chairman of the BOG also presides as Chairman of
the FOMC.
• The Governors as a group have 7 of the 12 votes–and
hence a majority of the votes–on the FOMC.
• Sets targets for the federal funds rate, issues directives
on security purchases & sales (OMO) to the trading desk
at the NY Fed
• The FOMC’s “balance of risks” is an assessment of
whether, in the future, its primary concern will be higher
inflation or a weaker economy.
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• Three key documents are prepared before each FOMC
meeting:
Green Book = Contains forecasts for the US economy
prepared by staff economists within the Research and
Statistics Division at the Federal Reserve Board.
Blue Book = Contains an outline of different monetary policy
options prepared by staff economists within the Monetary
Affairs Division at the Federal Reserve Board.
Beige Book = Contains a description of economic activity
within each of the 12 Federal Reserve districts. Prepared by
staff economists at each of the 12 Reserve Banks.
☼ Only the beige book is released to the public.
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Federal Advisory Council
• The directors of each bank select one banker from their
district to serve on the Federal Advisory Council
• The Council provides the Board of Governors with
information about conditions in the banking industry and in
the economy as a whole
• The Council advises the Board of Governors on the
possible effects of new banking regulations.
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Informal Structure of the Fed
• System designed to be highly decentralized, with 12
separate cooperating central banks. As responsibility for
controlling the health of the macroeconomy has evolved,
system has become much more centralized.
• Original design envisaged only one tool of monetary policy,
control of the discount rate. During the Great Depression
legislation(the Banking Acts of 1933 and 1935) gave BOG
control over OMO and reserve requirements, centralizing
power at the BOG.
• BOG frequently “suggests” a choice for president of a regional
Fed Bank to its directors.
• Member banks (the “owners” of the Fed) and the Federal
Advisory Council have become essentially frozen out of the
political process at the Fed.
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• Chairman of BOG has considerable effective control
through his ability to set the agenda at both BOG and
FOMC meetings, negotiation with congress and the
president, and his role as the spokesperson of the Fed.
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Central Bank Independence
• Instrument independence: the ability of the central bank
to set monetary policy instruments
• Goal independence: the ability of the central bank to set
the goals of monetary policy
• Political independence: independence from political
pressure
Factors Making the Fed Independent
• Once appointed & confirmed, members of board cannot
be fired or dismissed.
• Members of BOG have long terms (14 years)
• The chairman of the BOG has a 4-year term that
does not coincide with the president’s 4-year term.
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• Fed is financially independent
☼ It can control its own budget (free from the Congressional
appropriation process) with its substantial dividend
income(from government securities) and interest income
(from discount loans)
So, the Fed enjoys a high degree of autonomy with goal
independence, instrument independence, political
independence and financial independence; and yet it is
still subject to the influence of the Congress and the
president of the US. See below.
Factors Making the Fed Dependent
• Congress can pass legislation that would restrict Fed
independence
☼ Members of Congress are able to influence monetary policy, albeit
indirectly, through their ability to propose legislation that would
force the Fed to submit budget requests to Congress, as must
other government agencies
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• President appoints Chairman and Board members and
can influence legislation
Conclusion: Overall, the Fed is quite independent
Other Central Banks
• Bank of England: least independent: British government
makes policy decisions
• European Central Bank: the most independent -- price
stability primary goal
• Bank of Canada and Japan: have a fair degree of
independence, but not all on paper
• Trend to greater independence: New Zealand, European
nations
More and more governments have been granting greater
independence to their central banks in recent years.
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Explaining Central Bank Behavior
• Two Views of the Behavior of Bureaucracies
① Public interest view: They serve the public interest.
② The view of bureaucratic behavior theory: They often
serve their own interest
• The Theory of bureaucratic behavior
 Bureaucracies pursue to maximize their own welfare
(and, in so doing, may attempt to gain more power and
prestige, stronger independence, etc.)
 Central Bank: an example of principal-agent problem
(The Central bank is the agent and the general public
are the principals. Principals are too numerous and
disorganized to efficiently control their managers)
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• Implications for Central Banks
 Act to preserve independence
(The Fed has resisted vigorously congressional
attempts to limit the central bank’s autonomy)
 Try to avoid controversy by developing strategies
to avoid blame for mistakes
(The Fed has often been slow to raise interest rates in
order to avoid conflicts with President & Congress)
 Seek additional power over banks
(The Fed sought greater control over banks in the 1980s)
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Should the Fed Be Independent
Arguments against the Fed’s Independence
• Undemocratic -- puts too much power in the hands of
unelected Fed Governors.
☼ Since the Fed tends to be dominated by Wall Street and bond-market
interests, it tends to pursue overly tight monetary policies, in order to
keep inflation low, which serves the interests of those Wall Street
stock- and bondholders. (classic populist critique of the Fed)
• The Fed may not be accountable -- no provision to
replace bad members
☼ The principal-agent problem is perhaps worse for the Fed than for
congressmen since the former does not answer to the voters on
election day.
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• Makes it difficult to coordinate fiscal and monetary policy.
☼ In the early 1980's, for example, the Fed continued its ‘War on
Inflation’, which induced a severe recession, while Congress
passed a tax cut aimed at promoting economic recovery. Until the
Fed took its brakes off the economy in late 1982, the tax cut
showed no sign of working.
• Fed has often performed poorly
☼ Was impotent in Great Depression of 1929-33, let inflation get out
of control in late 1960's and 1970's.
Arguments for the Fed’s Independence
• A politically insulated Fed would be more concerned with
long-run objectives and thus be a defender of a sound
dollar and a stable price level.
☼ Political pressure would impart an inflationary bias to monetary
policy as politicians, driven by the desire to win reelection,
will tend to favor short-run monetary expansions.
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• A Federal Reserve under the control of Congress or the
president might make the so-called political business
cycle more pronounced.
☼ Political business cycles are common in countries where the central
bank is controlled by politicians
• Deficits are less likely to be inflationary with independent
Fed
☼ If not independent, the Treasury may pressure Fed to buy new
T-bonds, financing its spending by printing new money. (This is
called "monetizing the debt"). This phenomenon is very common in
Third World countries.
• The independence of the Federal Reserve System is a
key to its success in the US.
☼ Both theory and experience suggest that more independent
central banks produce better monetary policy. See chart below
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Central Bank Independence and
Macroeconomic Performance in 17 Countries
Countries where the central bank is not independent have
consistently higher rates of inflation on average than
countries with an independent central bank.
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