Central Banking

Arthur Centonze Slides 6

Central Bank Objectives

Price stability - to minimize distortion in information and in decision making - to create environment for growth Stable real growth and employment - to reduce fluctuations in business cycles - to provide a stable planning environment Financial stability - no systemic risk Stable interest rates - to provide a conducive environment for spending and borrowing - to lower risk premiums on LT bonds Stable exchange rates - to minimize price distortions, especially with trading partners - to provide predictability in trade contracts
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Price Stability: Is 0 Inflation Optimal?

Measurement difficulties policy mistakes deflation - rising real rates cost of capital - so: positive inflation rate = buffer At very low inflation: - nominal rates may be close to 0 - difficult for central bank to ease MP if economy weakens - the 0 Bound ECB, BOE, BOJ: < 2% US Fed: ?
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Central Banking Key Characteristics

1. Policy Framework
2. Credibility

3. Accountability
4. Transparency

5. Independence

1. Policy Framework
CB needs an explicit policy framework that defines: - its policy goals, e.g. price stability, growth, etc - its procedures for handling monetary problems - its flexibility in addressing competing goals - its predictability in responding to economic forces CB needs to communicate its framework to the financial markets and general public

Policy Communication
Although the federal funds rate is now close to zero, the Federal Reserve retains a number of policy tools that can be deployed against the crisis. One important tool is policy communication. Even if the overnight rate is close to zero, the Committee should be able to influence longer-term interest rates by informing the publics expectations about the future course of monetary policy. To illustrate, in its statement after its December meeting, the Committee expressed the view that economic conditions are likely to warrant an unusually low federal funds rate for some time. To the extent that such statements cause the public to lengthen the horizon over which they expect short-term interest rates to be held at very low levels, they will exert downward pressure on longer-term rates, stimulating aggregate demand. * * Ben Bernanke speech, The Crisis and the Policy Response, London School of Economics, January 13, 2009.

Time-Inconsistency Problem
Inability to consistently follow a good plan over time MP: tendency among central bankers to favor ST solution (economic growth) over a LT solution (price stability) - e.g. tendency to favor expansionary MP (e.g. low i) to grow GDP and employment - but: expansionary MP inflationary expectations demand for higher wages/prices, i.e. inflation vs. real growth Hence: policy of keeping inflation under control may be best LT solution Thus: solution to time-inconsistency problem: - develop reputation for credibility
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2. Credibility
CB needs to deliver on its promises and threats: - predictability credibility flexibility - 3 CB types: high, moderate, low inflation How achieve? - be mean! - incentivize central banker - replace central banker with a policy rule, e.g. let reserves grow at x% per year - increase accountability transparency independence

3. Accountability
Government establishes policy goals not CB CB reports publicly on progress in meeting goals Policymakers are subject to punishment: - incompetent replaced by competent

Works best when CB has single goal or a hierarchy of goals: - multiple goals trade-offs and priorities
Different systems exist to accomplish this among CBs

4. Transparency
Rooted in economic theory: - the absence of transparency uncertainty in financial markets ST volatility in asset prices real economy - the presence of transparency ability of financial markets to better predict the intent of monetary policy ST volatility in asset prices real economy Transparency on: - policy goals - policy decisions - outlook for future

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5. Independence
Appointments: by whom, how long, dismissal? Free to set policy without political influence: - no veto power by government Control over budget: - no obligation to finance government deficits Authority to make decisions for LT economic progress rather than ST political gain

Decision by committee: - pools knowledge and experience - reduces risk and increases legitimacy
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Problem 1
Many central banks use a ST interest rate as an instrument of monetary policy. In the context of the expectation theory of interest rates, how might transparency about the likely future path of ST interest rates increase the central banks ability to influence LT interest rates?

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US Federal Reserve Bank

19th century: multiple bank panics bank failures business failures - due to inability of banks to provide the needed liquidity for a growing and dynamic economy 1907: bank and business failures panic in securities markets - J. P. Morgan intervenes to save the financial system - demonstrated need for central bank to provide more stable monetary system: an elastic currency But: hostility of rural Americans to banks and to centralized authority created opposition to a central bank Result: decentralized Federal Reserve System: - to provide liquidity and stability, not MP FOMC established in 1933 to conduct MP
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Role of Federal Reserve System

Conduct MP - intermediate targets: interest rates and M - ultimate targets: prices, growth, employment Supervise and regulate member banks

Implement consumer protection laws (e.g. Truth in Lending Act)

Maintain the stability of the financial system to contain systemic risk

Provide financial services to depository institutions, US government, the public, and foreign official institutions

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Four Components of the System

Board of Governors 12 District Banks

Federal Open Market Committee (FOMC)

Member Banks

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Board of Governors
7 members appointed by president and confirmed by senate to 14 year terms, no renewals; one term expires every 2 years one appointed as chair, another as vice-chair Role of Board: - set the reserve requirement - approve changes to discount rate - analyze financial and economic conditions - approve bank merger applications - collect and publish statistics about the systems activities and the economy

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12 District Banks

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Role of District Banks

As the bank for the U.S. government: - assist in formulating and implementing MP - distribute new currency and coin and destroy old - maintain the U.S. Treasury's bank account As the bank for banks in the district: - hold deposits for all banks - operate the payments system for clearing checks and transferring funds for all banks - recommend changes to discount rate - make discount loans to member banks in the district - supervise, examine and regulate member banks

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New York Fed: Special Role

Handle systems OMO Handle FX interventions at direction of Treasury Manage US Treasurys borrowings: - auction and redeem treasury securities Maintain $ accounts, securities, and gold of foreign governments and institutions Maintain US gold stock Why? - district is home of largest US banks, securities and FX markets - President is permanent member of FOMC, and member of BIS

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Federal Open Market Committee

12 Members: 7 governors, 4 presidents (rotating), + president of NY Fed Chair of Fed = chair of FOMC Meets 8 times a year + conference calls between meetings Role of the FOMC: Set the target nominal federal funds rate to control the availability of money and credit: - instructs the open market account manager in the FRB of New York to buy and sell US Treasury securities to maintain the target FF rate: - sets nominal and real rates - releases policy directive at 2:15 pm after meeting - minutes after three weeks - transcript after five years

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European Central Banking

Swedens Riksbank: 1668 Bank of England: 1694 Banque de France: 1800 German Bundesbank: 1948

European Central Bank (ECB): 1998

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European Central Bank

Post WWII Europe: high budget deficits, high inflation, high and volatile interest rates, and unstable exchange rates. Led to: 1957: Treaty of Rome - Common Market as a customs union: - free flow of goods/services/capital - originally 6 countries, now 27 1990: Economic and Monetary Union (EMU) - movement toward 3 goals: - single CB, single MP, single currency - in three phases over 1990-99

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European Central Bank

1991: Treaty of Maastricht - EMU ratified and called for: - convergence: exchange rates and membership criteria - common currency (1-1-99): originally 11, now 16

Eurosystem ( Area): - European Central Bank (ECB): Frankfurt - National Central Banks (NCB): 16 European System of Central Banks (ESCB): 27 + 1

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Criteria for Monetary Union

1. Monetary - price stability: average inflation rate no higher than 1.5% above that of 3 best performing member states - LT interest rates: average nominal rates no higher than 2% above that of 3 best performing member states - exchange rates: no wide fluctuations, no devaluations in last 2 years 2. Fiscal - government budget deficit no greater than 3% of GDP - ratio of government debt to GDP no higher than 60% 3. Independent central bank

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ECB: Roles
Conducts MP Conducts FX operations Manages foreign reserves of euro area countries Operates payment systems

Issues currency
Manages financial crises
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ECB vs. Fed

ECB Executive Board (6) NCB (16) Governing Council (22) Meets 2x month Consensus Independent Information Reports to EP News conference Minutes - 20 years No transcript Fed Board of Governors (7) District Banks (12) FOMC (12) Meets every 6 weeks Formal vote Independent Information Reports to Congress Brief statement Minutes 3 weeks Transcript - 5 years
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ECB vs. Fed

Supervise banks Regulate Banks Implement consumer protection laws MP intervention Lender of last resort Control its budget National biases Focus on M growth Stated MP priority
ECB N N N N N N Y Y Y Fed Y Y Y Y Y Y N N N
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Bank of Japan
Created: 1882 Became independent from M of F: 1998 - 1980s: stock and real estate bubbles - 1990s: decade of stagnation and Asian financial crisis - led to many NPL, bank insolvencies, and meltdown of banking system On fiscal side, government ran large budget deficits to get economy moving: - but: wanted to demonstrate that BOJ had no plans to monetize deficits - so: gave independence to BOJ

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Role of Bank of Japan

Conducts MP Issues currency Provides payments and settlement services

Supervises and examines banks

Acts as lender of last resort Handles receipts and disbursements of treasury funds, including the issuance, payments and redemptions of government securities Handles FX operations as agent of M of F
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Bank of Japan: MP
9 member Policy Board - meets 2x per month - press conference to announce decision - minutes 1 month later, transcript 10 year later

Primary goal: price stability (0-2%) Secondary goal: LT economic growth Instruments: - buy and sell securities: ST call rate (comparable to US FF rate)

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Quantitative Easing
Central bank targets LT interest rates (not ST i) by buying LT government bonds: - thus: reducing effective interest rates on LT government bonds - flattening the yield curve - flooding the banking system with excess reserves and liquidity - encouraging banks to lend and stimulate economic activity affected by LT interest rates

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When? Deflation and 0 Bound

If inflation at rate of 1% per year (deflation) - and ST nom i cannot be set < 0 - then: ST real rate cannot be reduced < 1% - so: there is a lower limit on real ST rates that can be engineered by MP Thus: CB cannot spur growth and employment using its traditional policy tool of ST nom i But: CBs have little experience manipulating LT rates Quantitative easing experiments: BOJ, BOE, Fed
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Bank of Japan: 1990s Lost Decade + Deflation

To stimulate the economy and encourage spending: - BoJ reduced call rate to 0% from 2/99 8/00 (ZIRP) - the 0 Bound - but: now no room to ease MP by reducing ST call rate if economy needs more stimulus BOJ experimented with Quantitative Easing to attack the 0 Bound problem: - BOJ shifted from targeting ST call rate to targeting LT rates

- bought trillions of LT Japanese government bonds and flooded banks with excess reserves well above RR

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Bank of Japan: 0 Bound Experiment

Anticipated banks would lend them out or buy securities, thus driving down LT rates, flattening the yield curve, and stimulating LT investment - but: economy was weak, so not much demand for loans - and: banking system was weak (many NPL) - banks had low risk tolerance and wanted to hold reserves, not lend them out - also: LT rates already low (1.4% on 10 year government bonds) - experiment did not lower rates as anticipated See Stevens article on BOJ transparency as a response to failure of 0 Bound experiment

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Quantitative Easing: The Downside

Weakens currency as LT rates decline Potentially inflationary if not reversed when economy recovers - is some inflation good or bad at this time? - what, over time, could inflation do to LT rates? As yield curve flattens: what impact does this have on banks ability to earn profits?

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Problem 2
Why might the zero nominal interest rate bound lead policymakers to raise their inflation objective? Provide an option a CB might use to overcome a 0 bound problem?

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