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Central Banking

Arthur Centonze

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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 BankingKey Characteristics

1. Policy Framework

2. Credibility

3. Accountability

4. Transparency

5. Independence

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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

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Policy Communication

Although the federal funds rate is now close to zero, the FederalReserve retains a number of policy tools that can be deployedagainst the crisis. One important tool is policy communication.Even if the overnight rate is close to zero, the Committee should beable to influence longer-term interest rates by informing the publicsexpectations about the future course of monetary policy. To

illustrate, in its statement after its December meeting, the Committeeexpressed the view that economic conditions are likely to warrant anunusually low federal funds rate for some time. To the extent thatsuch statements cause the public to lengthen the horizon over whichthey expect short-term interest rates to be held at very low levels,they will exert downward pressure on longer-term rates, stimulatingaggregate demand. *

* Ben Bernanke speech, The Crisis and the Policy Response, LondonSchool of Economics, January 13, 2009.

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Time-Inconsistency Problem

Inability to consistentlyfollow a good plan over time MP: tendency among central bankers to favor ST

solution (economic growth) over a LT solution (pricestability)

- e.g. tendency to favor expansionary MP(e.g. low i) to grow GDP and employment- but: expansionary MP inflationaryexpectations demand for higher

wages/prices, i.e. inflation vs. real growth

Hence: policy of keeping inflation under control may bebest 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 reservesgrow at x% per year

- increase accountability

transparencyindependence

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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 ofgoals:

- multiple goals trade-offs and priorities

Different systems exist to accomplish this among CBs

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4. Transparency

Rooted in economic theory:- the absence of transparency uncertainty in financialmarkets ST volatility in asset prices realeconomy

- the presence of transparency ability of financial markets to

better predictthe intent of monetary policy ST volatility inasset 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 thanST 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 aninstrument of monetary policy. In the context of theexpectation theory of interest rates, how mighttransparency about the likely future path of ST interest

rates increase the central banks ability to influence LTinterest rates?

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US Federal Reserve Bank

19th century: multiple bank panics bank failures businessfailures- due to inability of banks to provide the needed liquidity for agrowing 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 authoritycreated opposition to a central bank

Result: decentralized Federal Reserve System:- to provide liquidity and stability, notMP

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 containsystemic 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 to14 year terms, no renewals; one term expires every 2 yearsone 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 targetnominal 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 targetFF 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 andvolatile 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 than1.5% 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 devaluationsin 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 FedExecutive Board (6) Board of Governors (7)NCB (16) District Banks (12)Governing Council (22) FOMC (12)

Meets 2x month Meets every 6 weeksConsensus Formal voteIndependent IndependentInformation InformationReports to EP Reports to CongressNews conference Brief statementMinutes - 20 years Minutes 3 weeksNo transcript Transcript - 5 years

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ECB vs. Fed

ECB Fed

Supervise banks N Y

Regulate Banks N Y

Implement consumer

protection laws N Y

MP intervention N Y

Lender of last resort N Y

Control its budget N Y

National biases Y N

Focus on M growth Y N

Stated MP priority Y 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 deficitsto 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 theissuance, 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) bybuying LT government bonds:

- thus: reducing effective interest rates on LT

government bonds- flattening the yield curve- flooding the banking system with excess reservesand 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 traditionalpolicy 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 Boundproblem:

- 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 drivingdown LT rates, flattening the yield curve, and stimulating LTinvestment

- 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 of0 Bound experiment

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Quantitative Easing:

The Downside Weakens currency as LT rates decline

Potentially inflationary if not reversed when economyrecovers

- 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 onbanks ability to earn profits?

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Problem 2

Why might the zero nominal interest rate bound leadpolicymakers to raise their inflation objective?

Provide an option a CB might use to overcome a 0

bound problem?