Structure of Central Banks &

The Federal Reserve System

Spring 2011

Korean Monetary Policy and the Financial System

"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 )

Boardroom BOG Washington, D.C.

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• Federal Reserve Act of 1913 established Federal Reserve System with its 12 regionalized banks

• 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.

A Brief History

• 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

• Americans’ fear of centralized power and distrust of moneyed interests prevented emergence of central bank

until early 20th century.

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Federal Open Market Committee (FOMC)

7 Governors and 5 FRB presidents

Board of Governors(BOG)

7 members including the Chairman

Member Banks

member commercial banks

Federal Advisory Council

12 members (bankers)

12 Federal Reserve Banks (FRBs)

Each with 9 directors who appoint president of the FRB

Formal Structure of the Federal Reserve System (the Fed) at a Glance

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Formal Structure & Allocation of Policy Tools in the Fed

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Often called the Federal Reserve Board, BOG is the decision making center of the Fed

• Headquartered in Washington DC.

• 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 14-

year terms as ordinary Board members when their terms of office end.

• Consists of 7 Governors including the Chairman

Board of Governors Board of Governors

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• Not more than one Governor can come from each Federal Reserve District.

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.

• Involved in making decisions regarding monetary policy.

Sets the reserve requirements

All seven Governors are voting members of the FOMC, which controls the monetary base, and thereby exerts the

most powerful influence on money supply.

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)

• Chairman of the BOG

Approves bank mergers and applications for new activities

Supervises the activities of foreign banks in the US Specifies the permissible activities of bank holding companies

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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Paul A. Volker (1979~83, 83~87)

Three Recent Fed Chairmen

• Appointed by President Carter, a Democrat, in August,1979

• 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

• During 1979-80, inflation was both rapid and strong with surging wage costs and prices in the aftermath of the 2nd oil shock.

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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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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.

• 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.

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Ben Bernanke (February 2006 ~ present)

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.

• Unlike Greenspan, uses clear and direct language

• Served as Chairman of CEA (Council of Economic Advisors) since June of 2005 until appointed as Chairman of the Fed by George Bush

“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 -

“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 -

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• 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

• Each regional Fed bank is a legally separate quasi-public institution. Why quasi-public?

• 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).

The Fed banks are non-profit and are legally required to turn over 100% of their profits to the Treasury.

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.

Federal Reserve BanksFederal Reserve Banks

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• Each Federal Reserve Bank has 9 directors, classified into three categories:

• 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.

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.

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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• 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.

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

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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

• 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 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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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

Federal Reserve Districts

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• 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)

Member Banks Member Banks

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• Meets 8 times (approximately every six weeks) per year, assesses the condition of the economy and votes on monetary policy in the coming weeks

▶ 2004 (Jan 28, Mar 16, May 4, June 30, Aug 10, Sept 21, Nov 10, Dec 14)

The committee that makes decisions regarding the conduct of open market operations (OMO) by a majority vote

• 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

• Policy-making arm of the Fed

FOMC (Federal Open Market Committee)FOMC (Federal Open Market Committee)

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• The Chairman of the BOG also presides as Chairman of 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.

• The other seven Reserve Bank presidents who do not vote still attend meetings and participate in debates and discussions.

• The Governors as a group have 7 of the 12 votes–and hence a majority of the votes–on the FOMC.

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• Three key documents are prepared before each FOMC meeting:

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.

Green Book = Contains forecasts for the US economy prepared by staff economists within the Research and Statistics Division at the Federal Reserve Board.

☼ Only the beige book is released to the public.

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• 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.

Federal Advisory CouncilFederal Advisory Council

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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.

• BOG frequently “suggests” a choice for president of a regional Fed Bank to its directors.

• 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.

• 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

• Once appointed & confirmed, members of board cannot be fired or dismissed.

• Members of BOG have long terms (14 years)

• 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

• The chairman of the BOG has a 4-year term that does not coincide with the president’s 4-year term.

Factors Making the Fed IndependentFactors Making the Fed Independent

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• Congress can pass legislation that would restrict Fed independence

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.

• Fed is financially independent

☼ 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

☼ 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)

Factors Making the Fed DependentFactors Making the Fed Dependent

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• 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

More and more governments have been granting greater independence to their central banks in recent years.

Conclusion: Overall, the Fed is quite independent

• President appoints Chairman and Board members and can influence legislation

• Trend to greater independence: New Zealand, European nations

Other Central BanksOther Central Banks

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• Two Views of the Behavior of Bureaucracies

• The Theory of bureaucratic behavior

① Public interest view: They serve the public interest.

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)

② The view of bureaucratic behavior theory: They often serve their own interest

Bureaucracies pursue to maximize their own welfare (and, in so doing, may attempt to gain more power and

prestige, stronger independence, etc.)

Explaining Central Bank BehaviorExplaining Central Bank Behavior

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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

Seek additional power over banks

(The Fed has often been slow to raise interest rates in order to avoid conflicts with President & Congress)

(The Fed sought greater control over banks in the 1980s)

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• Undemocratic -- puts too much power in the hands of unelected Fed Governors.

Arguments against the Fed’s Independence

• The Fed may not be accountable -- no provision to replace bad members

☼ 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 principal-agent problem is perhaps worse for the Fed than for congressmen since the former does not answer to the voters on election day.

Should the Fed Be IndependentShould the Fed Be Independent

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• Fed has often performed poorly

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.

• Makes it difficult to coordinate fiscal and monetary policy.

☼ Was impotent in Great Depression of 1929-33, let inflation get out of control in late 1960's and 1970's.

☼ 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.

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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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