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Unit 3

Structure of Central Banks and the Federal Reserve System

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Origins of the Federal Reserve System

Resistance to establishment of a central bank Fear of centralized power Distrust of moneyed interests

First U.S. experiments with a central bank terminated in 1811 and in 1836

No lender of last resort Nationwide bank panics on a regular basis Panic of 1907 so severe that the public was convinced a

central bank was needed Federal Reserve Act of 1913

Elaborate system of checks and balances Decentralized

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Problems with the Fractional Reserve Banking System

Lack of flexibility: If a seasonal or panic-induced withdrawal of currency from

banks occurred, pressure would converge on the larger banks as small banks drew down their deposits to obtain cash for their customers.

Major banking and financial market panics occurred in 1857, 1873, 1884, 1893, and 1907.

No lender of last resort stood ready to provide temporary cash reserves to the banking system in times of crisis.

The Fed was created by the Federal Reserve Act, which was signed into law by President Woodrow Wilson in December, 1913.

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Federal Reserve Act A compromise among diverse forces and interests:

between the government and the private sector; among the various geographic regions of the nation; between rural and urban interests, and among bankers, the non-bank business sector, and the rest of society.

Original Mandate: to serve as a lender of last resort to the banking system; to issue currency; to improve on the check collection process; to serve as banker or fiscal agent for the U.S. Treasury, and to improve the supervision and examination of the nation's banks.

Current Mandate: Economic stabilization, Price stabilization, and Encouraging full employment.

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The Structure Of The Federal Reserve System

7-person Board of Governors: appointed by the president of the United States for one

14-year term, subject to confirmation by the U.S. Senate Major responsibilities include:

setting the levels of reserve requirements; reviewing and "determining" the level of the discount rates set by

the twelve individual district Federal Reserve banks; establishing bank supervision and examination procedures; evaluating applications for bank mergers and acquisitions; setting margin requirements for the purchase of stocks and

bonds, and serving as voting members on the important Federal Open

Market Committee (FOMC). FOMC formulates the basic posture of monetary policy and buys and

sells securities with a view toward influencing credit availability, short-term interest rates, and monetary conditions throughout the nation.

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The District Federal Reserve Banks

Each district Federal Reserve Bank: is an incorporated institution, owned by the

Federal Reserve member banks of the district, and

is governed by a nine-person board of directors, six of whom are elected by commercial bankers and three of whom are appointed by the Board of Governors in Washington. 3 professional bankers 3 prominent business leaders 3 representing areas other than banking and business

sectors

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Functions of the Federal Reserve Banks

Clear checks

Issue new currency

Withdraw damaged currency from circulation

Administer and make discount loans to banks in their districts

Evaluate proposed mergers and applications for banks to expand their activities

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Functions of the Federal Reserve Banks (cont’d)

Act as liaisons between the business community and the Federal Reserve System

Examine bank holding companies and state-chartered member banks

Collect data on local business conditions

Use staffs of professional economists to research topics related to the conduct of monetary policy

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Federal Reserve Banks and Monetary Policy

Directors “establish” the discount rate

Decide which banks can obtain discount loans

Directors select one commercial banker from each district to serve on the Federal Advisory Council which consults with the Board of Governors and provides information to help conduct monetary policy

Five of the 12 bank presidents have a vote in the Federal Open Market Committee (FOMC)

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Member Banks All national banks are required to be members

of the Federal Reserve System (currently about 7,800 commercial banks are members)

Commercial banks chartered by states are not required but may choose to be members

Depository Institutions Deregulation and Monetary Control Act of 1980 subjected all banks to the same reserve requirements as member banks and gave all banks access to Federal Reserve facilities

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Board of Governors of the Federal Reserve System

Seven members headquartered in Washington, D.C.

Appointed by the president and confirmed by the Senate

14-year non-renewable term

Required to come from different districts

Chairman is chosen from the governors and serves four-year term

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Duties of the Board of Governors

Votes on conduct of open market operations

Sets reserve requirements

Controls the discount rate through “review and determination” process

Sets margin requirements

Sets salaries of president and officers of each Federal Reserve Bank and reviews each bank’s budget

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Duties of the Board of Governors (cont’d)

Approves bank mergers and applications for new activities

Specifies the permissible activities of bank holding companies

Supervises the activities of foreign banks operating in the U.S.

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Chairman of the Board of Governors

Advises the president on economic policy

Testifies in Congress

Speaks for the Federal Reserve System to the media

May represent the U.S. in negotiations with foreign governments on economic matters

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Federal Open Market Committee (FOMC)

Meets eight times a year

Consists of seven members of the Board of Governors, the president of the Federal Reserve Bank of New York and the presidents of four other Federal Reserve banks

Chairman of the Board of Governors is also chair of FOMC

Issues directives to the trading desk at the Federal Reserve Bank of New York

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FOMC Meeting Report by the manager of system open market operations on

foreign currency and domestic open market operations and other related issues

“Green Book” forecast Go-round

Current monetary policy and domestic policy directive “Blue book”

Presentation on relevant Congressional actions Public announcement about the outcome of

the meeting

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Chairman Runs the Show Spokesperson for the Fed and

negotiates with Congress and the President

Sets the agenda for meetings

Speaks and votes first about monetary policy

Supervises professional economists and advisers

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Allocation of Power within the Federal Reserve System

Board of Governors in Washington has more power than the district Federal Reserve banks.

Board of Governors in Washington can veto a districts choice of district Federal Reserve bank president.

Though the discount rate is set by each district Federal Reserve bank, it is subject to "review and determination" by the Board of Governors.

Decisions to purchase government securities are made in Washington by the FOMC.

Federal Reserve Bank of New York is the first among equals.

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The Question Of Federal Reserve Independence

Relative to many other nations’ central banks, the Federal Reserve System enjoys considerable independence from governmental influence—either the executive or legislative branches.

The Fed's independence was created deliberately by the authors of the Federal Reserve Act.

Indicators of independence: nonrenewable 14-year terms of the members of the Board

of Governors, and the Fed's operating revenues are derived from its portfolio

of securities rather than from Congressional appropriations.

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Other Central Banks

Bank of England least independent: Govt. makes policy decisions

European Central Bank: most independent—price stability primary goal

Bank of Canada and Japan: fair degree of independence, but not all on paper

Trend to greater independence: New Zealand, European nations

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Independence of the Federal Reserve May be Overstated

The president appoints Chairmen and Board members and can influence legislation.

The Fed is frequently involved in Congressional legislation concerning bank regulation.

The Constitution grants authority to Congress to revoke the authority given to the Federal Reserve.

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The Case For Federal Reserve Independence

An independent Fed likely has longer-run objectives, politicians don't. Political business cycles

Less likely deficits will be inflationary. Politicians love to spend money, but hate to levy

taxes to pay for the expenditures. Tendency to monetize fiscal deficit, leading to

inflation. An independent Fed guards price level stability.

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The Case Against Federal Reserve Independence

Those responsible for monetary policy should be accountable to the electorate.

Various elements of national economic policy need to be coordinated Fiscal and monetary policy

The Federal Reserve has not used its independence effectively over the years.

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European Central Bank Patterned after the Federal Reserve Central banks from each country play similar

role as Fed banks Executive Board

President, vice-president and four other members

Eight year, nonrenewable terms Governing Council

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Differences National Central Banks control their own

budgets and the budget of the ECB

Monetary operations are not centralized

Does not supervise and regulate financial institutions

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Governing Council

Monthly meetings at ECB in Frankfurt, Germany

Twelve National Central Bank heads and six Executive Board members

Operates by consensus ECB announces the target rate and takes

questions from the media To stay at a manageable size as new

countries join, the Governing Council will be on a system of rotation

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ECB Independence Most independent in the world Long terms Determines own budget Less goal independent

Price stability Charter cannot by changed by legislation;

only by revision of the Maastricht Treaty

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Central Bank Behavior Theory of bureaucratic behavior—

objective is to maximize its own welfare which is related to power and prestige Fight vigorously to preserve autonomy Avoid conflict with more powerful groups

Does not rule out altruism