8/2/2019 FIN644 - Slides 6
1/42
1
Central Banking
Arthur Centonze
Slides 6
8/2/2019 FIN644 - Slides 6
2/42
2
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
8/2/2019 FIN644 - Slides 6
3/42
3
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: ?
8/2/2019 FIN644 - Slides 6
4/42
4
Central BankingKey Characteristics
1. Policy Framework
2. Credibility
3. Accountability
4. Transparency
5. Independence
8/2/2019 FIN644 - Slides 6
5/42
5
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
8/2/2019 FIN644 - Slides 6
6/42
6
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.
8/2/2019 FIN644 - Slides 6
7/42
7
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
8/2/2019 FIN644 - Slides 6
8/42
8
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
8/2/2019 FIN644 - Slides 6
9/42
9
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
8/2/2019 FIN644 - Slides 6
10/42
10
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
8/2/2019 FIN644 - Slides 6
11/42
11
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
8/2/2019 FIN644 - Slides 6
12/42
12
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?
8/2/2019 FIN644 - Slides 6
13/42
13
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
8/2/2019 FIN644 - Slides 6
14/42
14
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
8/2/2019 FIN644 - Slides 6
15/42
15
Four Components of the System
Board of Governors
12 District Banks
Federal Open Market Committee (FOMC)
Member Banks
8/2/2019 FIN644 - Slides 6
16/42
16
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
8/2/2019 FIN644 - Slides 6
17/42
17
12 District Banks
8/2/2019 FIN644 - Slides 6
18/42
18
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
8/2/2019 FIN644 - Slides 6
19/42
19
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
8/2/2019 FIN644 - Slides 6
20/42
20
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
8/2/2019 FIN644 - Slides 6
21/42
21
8/2/2019 FIN644 - Slides 6
22/42
22
8/2/2019 FIN644 - Slides 6
23/42
23
European Central Banking
Swedens Riksbank: 1668
Bank of England: 1694
Banque de France: 1800
German Bundesbank: 1948
European Central Bank (ECB): 1998
8/2/2019 FIN644 - Slides 6
24/42
24
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
8/2/2019 FIN644 - Slides 6
25/42
25
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
8/2/2019 FIN644 - Slides 6
26/42
26
8/2/2019 FIN644 - Slides 6
27/42
27
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
8/2/2019 FIN644 - Slides 6
28/42
28
ECB: Roles
Conducts MP
Conducts FX operations
Manages foreign reserves of euro area countries
Operates payment systems
Issues currency
Manages financial crises
8/2/2019 FIN644 - Slides 6
29/42
29
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
8/2/2019 FIN644 - Slides 6
30/42
30
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
8/2/2019 FIN644 - Slides 6
31/42
31
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
8/2/2019 FIN644 - Slides 6
32/42
32
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
8/2/2019 FIN644 - Slides 6
33/42
33
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)
8/2/2019 FIN644 - Slides 6
34/42
34
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
8/2/2019 FIN644 - Slides 6
35/42
35
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
8/2/2019 FIN644 - Slides 6
36/42
36
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
8/2/2019 FIN644 - Slides 6
37/42
37
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
8/2/2019 FIN644 - Slides 6
38/42
38
8/2/2019 FIN644 - Slides 6
39/42
39
8/2/2019 FIN644 - Slides 6
40/42
40
8/2/2019 FIN644 - Slides 6
41/42
41
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?
8/2/2019 FIN644 - Slides 6
42/42
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?
Top Related