1 the european central bank (ecb) and the federal reserve (the fed): differences and similarities in...

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The European Central Bank (ECB) The European Central Bank (ECB) and the Federal Reserve (the and the Federal Reserve (the

Fed): Fed):

differences and similarities in differences and similarities in setup, operational procedure, and setup, operational procedure, and

monetary policymonetary policy

Akmal Rahimov Akmal Rahimov

Hari WidodoHari Widodo

Yudha HadiyantoYudha Hadiyanto

International Financial International Financial EconomicsEconomics

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OUTLINE:

• PART I : General Overview, Historical Background, Organizational Structure, Main Functions and Tasks of the Federal Reserve and ECB

• PART II : Differences and similarities in Operational Procedures of Federal Reserve and European Central Bank

• PART III : Monetary Policy

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PART I:PART I:General Overview, Historical Background, General Overview, Historical Background,

Organizational Structure, Main Functions and Organizational Structure, Main Functions and Tasks of the Federal Reserve Bank Tasks of the Federal Reserve Bank and European Central Bank (ECB)and European Central Bank (ECB)

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The Role of Central BankThe Role of Central Bank

Issuer of the Issuer of the currencycurrency

Controller of the Controller of the money supplymoney supply

Lender of the Last Lender of the Last ResortResort

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Why the US need a central bank?Why the US need a central bank?

1.The United States lacked a central bank until the twentieth century

2.Needs a money manager, to handle the nation's financial system.

3.Financial panics, the Bank Panic of 1907 convinced the public that a central bank was necessary.

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Why the US need a central bank?Why the US need a central bank?(Continued)(Continued)

4.To reform the financial system to be more integrated and secure in supporting the developing economy.

5. In 1913, after considerable debate, Congress passed the Federal Reserve Act to balance the financial needs of the country.

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Why European System of Central Bank Why European System of Central Bank (ESCB) is needed?(ESCB) is needed?

1. Primary objective : to maintain price stability, as defined in Article 2 of the Statute of the ESCB and of the ECB.

2. Price stability : a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2%. To be maintained over the medium term.

3. The Governing Council announced that, in the pursuit of price stability, it would aim to maintain inflation rates close to 2% over the medium term.

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Historical BackgroundHistorical BackgroundFEDERAL RESERVE FEDERAL RESERVE

Drafted by Congress as the Drafted by Congress as the Federal Reserve Act in 1913Federal Reserve Act in 1913

The act began in 1908, when The act began in 1908, when Congress set up the National Congress set up the National Monetary Commission to Monetary Commission to pinpoint weaknesses in the pinpoint weaknesses in the nation’s financial system. nation’s financial system.

Triggering Factors : Monetary Triggering Factors : Monetary panicpanic(Bank commitment) (Bank commitment)

The commission found that The commission found that the United States lacked a the United States lacked a reliable method to provide reliable method to provide liquidity to the money supply. liquidity to the money supply.

EUROPEAN CENTRAL BANKEUROPEAN CENTRAL BANK

Established on 1 June 1998, as Established on 1 June 1998, as one of the world’s youngest one of the world’s youngest central banks. central banks.

Triggering factors : the presence Triggering factors : the presence of EMU (political decision), i.e. to of EMU (political decision), i.e. to maintain price stabilitymaintain price stability

EMU:EMU:

o Stage 1: Restriction on the Stage 1: Restriction on the movement of capital were movement of capital were abolished (1990)abolished (1990)

o Stage 2:Establishment of Stage 2:Establishment of EMI and ECBEMI and ECB

o Stage 3:Irrevocable fixing of Stage 3:Irrevocable fixing of exchange rateexchange rate

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Historical Background(Continued)Historical Background(Continued)

► President Woodrow President Woodrow Wilson signed the Wilson signed the Federal Reserve Act Federal Reserve Act into law on Dec. 23, into law on Dec. 23, 1913, to help to 1913, to help to maintain a stable, maintain a stable, healthy and growing healthy and growing economy.economy.

◊ The legal basis : the Treaty The legal basis : the Treaty on European Union signed on on European Union signed on February 7, 1992 in Maastricht February 7, 1992 in Maastricht which established the which established the European Community. European Community.

◊The ESCB is composed of the The ESCB is composed of the ECB and the national central ECB and the national central banks of all 15 EU Member banks of all 15 EU Member States. States.

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Stages to Monetary UnionStages to Monetary Union

1.1. Maastricht TreatyMaastricht Treaty

2.2. Establishment of the EMUEstablishment of the EMU

3.3. Irrevocable fixing of exchange ratesIrrevocable fixing of exchange rates

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Inseparable Story: EMU and the Inseparable Story: EMU and the ECBECB

Stage 1: Maastricht TreatyStage 1: Maastricht Treaty1. 1 July 1990, the first stage : movement of capital

among the European Economic Community (EEC) countries should be demolished. the committee of governors decided to facilitate the preparatory work for the establishment of EMU (the Treaty of Rome)

2. 1991 intergovernmental conference agreed to revise the Treaty of Rome in order to establish the required institutional structure. Represented on the Treaty on European Union, signed in Maastricht on February 7, 1992.

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Stage 2 : Establishment of the Stage 2 : Establishment of the EMUEMU

1.1. 1 January 1994 : The establishment of the 1 January 1994 : The establishment of the European Monetary Institute (EMI)European Monetary Institute (EMI)The EMI had The EMI had no responsibility for the conduct of monetary policy no responsibility for the conduct of monetary policy in the European Unionin the European Union

2.2. December 1995 : the European Council agreed to December 1995 : the European Council agreed to name the European currency unit to be introduced name the European currency unit to be introduced the "euro"the "euro", and confirmed that Stage Three of , and confirmed that Stage Three of EMU would start on 1 January 1999. EMU would start on 1 January 1999.

3.3. December 1996 EMI also presented to the December 1996 EMI also presented to the European Council, and subsequently to the public, European Council, and subsequently to the public, the selected design series for the euro banknotes to the selected design series for the euro banknotes to be put into circulation on be put into circulation on 1 January 20021 January 2002. .

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4.4. 25 May 1998 : the governments of the 25 May 1998 : the governments of the 11 participating Member States 11 participating Member States ((Belgium, Germany, Spain, France, Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the Ireland, Italy, Luxembourg, the Netherlands, Austria, PortugalNetherlands, Austria, Portugal and and Finland) Finland) appointed the President, the appointed the President, the Vice-President and the four other Vice-President and the four other members of the Executive Board of the members of the Executive Board of the ECB. ECB.

• With the establishment of the ECB on 1 With the establishment of the ECB on 1 June 1998, the EMI had completed its June 1998, the EMI had completed its tasks. The EMI went into liquidation on tasks. The EMI went into liquidation on the establishment of the ECB.the establishment of the ECB.

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Stage 3: Irrevocable fixing of Stage 3: Irrevocable fixing of exchange rates exchange rates

1 January 1999 : the irrevocable fixing of 1 January 1999 : the irrevocable fixing of the exchange rates of the currencies of the the exchange rates of the currencies of the 11 Member States initially participating in 11 Member States initially participating in Monetary Union was commenced along Monetary Union was commenced along with the conduct of a single monetary with the conduct of a single monetary policy under the responsibility of the ECB. policy under the responsibility of the ECB.

1 January 2001 : Greece joined the EMU, 1 January 2001 : Greece joined the EMU, making the number of participating making the number of participating Member States increased to 12. Member States increased to 12.

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Basic Tasks of Federal Reserve and European Central Basic Tasks of Federal Reserve and European Central BankBank

Federal ReserveFederal Reserve manages supply of money manages supply of money

and creditand credit

keeps the wheels of keeps the wheels of business rollingbusiness rolling

serves as the banker for serves as the banker for the federal government by the federal government by providing financial providing financial services for the U.S. services for the U.S. Department of the Department of the TreasuryTreasury

supervises and regulates a supervises and regulates a

large share of the nation's large share of the nation's banking and financial banking and financial system; system;

administers banking and administers banking and finance-related consumer finance-related consumer protection laws. protection laws.

European Central BankEuropean Central Bank To define and implement To define and implement

monetary policy in Euro monetary policy in Euro areaarea

To maintain price stability To maintain price stability and conduct foreign and conduct foreign exchange operationsexchange operations

Holding and manage the Holding and manage the official foreign reserves of official foreign reserves of the Member Statesthe Member States

Promote the smooth Promote the smooth operation of payment operation of payment systemssystems

Provide prudential Provide prudential supervision of credit supervision of credit institutions and the institutions and the stability of the financial stability of the financial system system

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Independence of the Central BankIndependence of the Central Bank

The ECB:Based on the Maastricht Treaty, neither ECB nor NCB nor any member of decision-making bodies are allowed to seek or to take instructions from community institution or bodies form any government of any member states or from any other bodies

The Fed:Three structural features give the Fed independence in its conduct of monetary policy:- The appointment procedure for Governor,- The appointment procedure for Reserve Bank Presidents- Funding.

However, it is ultimately countable to Congress and come under government audit and review

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Structure of the System of Federal Structure of the System of Federal ReserveReserve

Board of Governors of the Federal Reserve

Federal Open Market Committee

Federal Reserve Banks in

12 DistrictsMember banks Advisory Committees

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Board of Governor of The FedBoard of Governor of The Fed

1. Seven-member Board of Governors.

2. Appointed by the President of the United States and confirmed by the Senate

3. Serve 14-year terms, arranged so that one expires in every even-numbered year. designed to be long enough to prevent day-to-day political pressures

4. The President of the United States designates a Chairman and Vice Chairman from the Board to serve four-year terms.

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Federal District Bank (12)Federal District Bank (12)

District Banks. District Banks. There are 12 Federal There are 12 Federal Reserve Districts, or regions, throughout Reserve Districts, or regions, throughout the United States. Regional headquarters the United States. Regional headquarters are located in Boston, New York, are located in Boston, New York, Philadelphia, Cleveland, Richmond, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. Kansas City, Dallas, and San Francisco. Additionally, there are Branches of Additionally, there are Branches of Reserve Banks in 25 other cities.Reserve Banks in 25 other cities.

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Federal Reserve Districts and Branches

1. Boston2. New York3. Philadelphia4. Cleveland5. Richmond6. Atlanta

7.7. ChicagoChicago8.8. Saint LouisSaint Louis9.9. MinneapolisMinneapolis10.10.Kansas CityKansas City11.11.DallasDallas12.12.San FranciscoSan Francisco

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Federal Open Market CommitteeFederal Open Market Committee

1. The Federal Open Market Committee (FOMC) consists of twelve members

• The seven members of the Board of Governors of the Federal Reserve System

• The president of the Federal Reserve Bank of New York;

• Four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis.

2. Nonvoting Reserve Bank presidents attend the meetings of the Committee, participate in the discussions, and contribute to the Committee's assessment of the economy and policy options.

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Federal Open Market CommitteeFederal Open Market Committee

The FOMC has the primary responsibility for The FOMC has the primary responsibility for conducting monetary policy. conducting monetary policy.

Director of each Reserve Bank contributes to Director of each Reserve Bank contributes to monetary policy by making recommendations monetary policy by making recommendations about the appropriate discount rateabout the appropriate discount rate

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Member BanksMember Banks

National banks chartered by the federal government are, by law, members of the Federal Reserve System. State-chartered banks may choose to become members of the Federal Reserve System if they meet the standards set by the Board of Governors.

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Advisory CommitteeAdvisory CommitteeThe Federal Reserve System uses advisory and working committees to advise the Board of Governors directly:

• Federal Advisory Council. Consists of one member—traditionally a commercial banker—from each Federal Reserve District.Required by law to meet four times each year with the Board of Governors to discuss economic and banking matters.

• Consumer Advisory Council. This statutory council has thirty members, meets with the Board three times a year on matters concerning consumers and the consumer credit protection laws administered by the Board. Consists of academics, legal specialists in consumer matters, and members representing the interests of consumers and the financial industry.

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• Thrift Institutions Advisory Council.

Board of Governors established this council to obtain information and opinions on the needs and problemsof thrift institutions. The council is made up of representativesof savings and loan associations, savings banks, and creditunions.

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Flow of Command in the FEDFlow of Command in the FED

2727Source : ECB Brochure

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Executive Board1.1. The Executive BoardThe Executive Board comprises the President, the comprises the President, the

Vice-President and four other members.Vice-President and four other members.

2.2. The main responsibilities of the Executive Board are: The main responsibilities of the Executive Board are: • To implement monetary policy and, in doing so, To implement monetary policy and, in doing so,

to give the necessary instructions to the NCBs; to give the necessary instructions to the NCBs;

• To execute those powers which have been To execute those powers which have been delegated to it by the Governing Council of the delegated to it by the Governing Council of the ECB.ECB.

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Governing and General Council1. The Governing Council is the supreme decision-

making body of the ECB which comprises the members of the Executive Board of the ECB and the governors of the national central banks which have adopted the euro.

2. Only members of the Governing Council present in person shall have the right to vote.

3. General Council is one of the three decision-making bodies of the ECB. It comprises the President and the Vice-President of the ECB and the governors of all 15 EU national central banks.

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PART II:PART II:Differences and similarities in Differences and similarities in

Operational Procedures of Federal Operational Procedures of Federal Reserve and European Central Reserve and European Central

BankBank

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Operational Procedure

Operational Procedure is the set of instruments and procedures which a central bank uses to steer interest rate, signal monetary policy intentions, and manage liquidity in the money market.

Operational Procedures related to the monetary policy and the instruments used such as open market Operation, standing facilities, and reserve requirement.

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Monetary Policy FrameworkMonetary Policy Framework

ECB: ECB: • Primary objective of ECB is Primary objective of ECB is

maintaining the price maintaining the price stability.stability.

• Operationally defined as Operationally defined as controlling inflation to be controlling inflation to be less 2% in Harmonized less 2% in Harmonized Index Consumer Prices Index Consumer Prices (HICP).(HICP).

• In evaluating the financial In evaluating the financial market condition, (M3) as market condition, (M3) as quantitative reference. quantitative reference.

• Prediction of inflation and Prediction of inflation and the risk price stability is the risk price stability is crucial (broad based crucial (broad based assessment)assessment)

The Fed:

• controlling inflation and promote economic growth

• There is no exact figure as reference of the price stability and inflation.

• Board of Governor and FOMC maintain growth of money and credit in line with the long-run economic performance such as employment rate, inflation rate, and moderate interest rate.

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Monetary Policy FrameworkMonetary Policy Framework• ECB announces target of ECB announces target of

money growth periodically money growth periodically since its inception since its inception

• Using M3 as the evaluation Using M3 as the evaluation tool to the financial market tool to the financial market condition has some condition has some technical problem.technical problem.

• M3 is defined as currency, M3 is defined as currency, deposits, and marketable deposits, and marketable securities held by Euro-securities held by Euro-area resident. area resident.

• The fed has been announcing the target of money growth since 2002.

• The Fed does not have such kind of problems

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Operational Procedure :

Both central banks use the similar tools but different method in managing money market and influencing short-term interest rate

1. The ECB influence the liquidity in the market through the open market operation based on weekly pre-arranged schedule The instrument used in this operation is essentially repurchase agreement like in the Fed.

2. ECB uses minimum reserve to stabilize money market interest rates. The ECB requires bank to hold required reserve based on the level of the liabilities.

1. The Fed uses the Open Market Operation through over-night repurchase agreement in influencing market liquidity and. the two other tools, i.e reserve requirement and discount rate. Level of supply is determined every morning based on forecast for reserve demand.

2. Reserve requirement is not used to influence inflation and growth, but to stabilize the demand for reserve to make easier to control the fed fund rate.

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3. ECB also provides overnight loans to banks with the marginal lending rate. The spread is determined by governing council.

4. The open market operations are done simultaneously by the NCB in the Euro-system.

5. The OMO involving coordination among 15 NCB and hundreds financial institutions. It becomes more complicated.

3. The Fed provide loan at the discount window. The discount rate is subject to approval from the board of governors.

4. Estimate the demand for reserves, and estimates the supply before any other open market operation, and arrange additional open market operations.

5. The Fed conducts the OMO through the Fed of NY and involving a fewer financial institution.

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6.6. Due to the differences in Due to the differences in financial structure among financial structure among the countries, ECB deals the countries, ECB deals with more various with more various collateral collateral

7. The sheer volume of funds 7. The sheer volume of funds that is refinanced on that is refinanced on regular basis is larger than regular basis is larger than that of the Fed therefore that of the Fed therefore ECB set up more ECB set up more cumbersome and risky. cumbersome and risky.

6.The Fed only deals with the US government securities as collateral.

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PART III: Monetary PolicyPART III: Monetary Policy

Macroeconomic PerformanceMacroeconomic Performance

Monetary Policy InstrumentsMonetary Policy Instruments

Monetary Policy Strategies Monetary Policy Strategies

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Key economic characteristics of the Euro Area, US and JapanKey economic characteristics of the Euro Area, US and Japan

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Unemployment rate in the Euro Area, the United States and Unemployment rate in the Euro Area, the United States and JapanJapan

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Monetary InstrumentsMonetary Instruments

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Tools of Monetary Policy of Federal Reserve Tools of Monetary Policy of Federal Reserve and ECBand ECB

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The instruments of ECB’s monetary policyThe instruments of ECB’s monetary policy

1.1. Open market operationsOpen market operations

The The main refinancing operationsmain refinancing operations are are regular liquidity-providing reverse regular liquidity-providing reverse transactions with a weekly frequency and transactions with a weekly frequency and a maturity of two weeks. a maturity of two weeks.

The The longer-term refinancing longer-term refinancing operationsoperations are liquidity-providing are liquidity-providing reverse transactions with a monthly reverse transactions with a monthly frequency and a maturity of three frequency and a maturity of three months. months.

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Fine-tuning operationsFine-tuning operations can be executed on can be executed on an ad hoc basis with the aim of both an ad hoc basis with the aim of both managing the liquidity situation in the market managing the liquidity situation in the market and steering interest rates, in particular in and steering interest rates, in particular in order to smooth the effects on interest rates order to smooth the effects on interest rates caused by unexpected liquidity fluctuations. caused by unexpected liquidity fluctuations.

In addition, the Eurosystem may carry out In addition, the Eurosystem may carry out structural operationsstructural operations through the issuance through the issuance of debt certificates, reverse transactions and of debt certificates, reverse transactions and outright transactions. outright transactions.

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2.2. Standing facilitiesStanding facilities aim to provide and aim to provide and absorb overnight liquidity, signal the general absorb overnight liquidity, signal the general monetary policy stance and bound overnight monetary policy stance and bound overnight market interest rates. market interest rates.

Marginal lendingMarginal lending facility facility, is used by , is used by counterparties to obtain overnight liquidity counterparties to obtain overnight liquidity from the NCBs against eligible assets. from the NCBs against eligible assets.

Deposit facilityDeposit facility to make overnight deposits to make overnight deposits

with the NCBs.with the NCBs.

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3. Minimum reserves 3. Minimum reserves The Governing Council of the ECB has decided The Governing Council of the ECB has decided

to apply minimum reserves as an integral part to apply minimum reserves as an integral part of the operational framework for the monetary of the operational framework for the monetary policy in Stage Three. policy in Stage Three.

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Three Tools of Federal Reserve Three Tools of Federal Reserve Monetary PolicyMonetary Policy

1.Establishing 1.Establishing reserve requirementsreserve requirements, the minimum , the minimum proportion (percentage) of bank deposits they must proportion (percentage) of bank deposits they must keep on deposit at the Fed.keep on deposit at the Fed.

Increasing reserve requirements (%) increases Increasing reserve requirements (%) increases the percentage of bank deposits kept in non-the percentage of bank deposits kept in non-interest bearing deposits at the Fed and limits interest bearing deposits at the Fed and limits bank lending.bank lending.

Decreasing reserve requirements (%) reduces the Decreasing reserve requirements (%) reduces the percentage of bank deposits kept in the Fed and percentage of bank deposits kept in the Fed and provides the banking system with excess provides the banking system with excess reserves.reserves.

Bank deposits (reserves) in the Fed are needed to Bank deposits (reserves) in the Fed are needed to clear checks and to satisfy reserve requirements.clear checks and to satisfy reserve requirements.

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Three Tools of Federal Reserve Three Tools of Federal Reserve Monetary Policy (Continued)Monetary Policy (Continued)

2.2. Open market operationsOpen market operations affect the level of affect the level of member bank reserves and the monetary base.member bank reserves and the monetary base.

Buying government securities from the private Buying government securities from the private sector, the Fed eventually credits member bank sector, the Fed eventually credits member bank deposits, thus increasing the level of bank deposits, thus increasing the level of bank reserves and the banks' ability to make loans reserves and the banks' ability to make loans and expand the money supply.and expand the money supply.

Selling securities (could be any asset) to private Selling securities (could be any asset) to private security dealers or banks, the Fed is paid with a security dealers or banks, the Fed is paid with a bank check which reduces the level of member bank check which reduces the level of member bank actual reservesbank actual reserves

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Three Tools of Federal Reserve Three Tools of Federal Reserve Monetary Policy (Continued)Monetary Policy (Continued)

3.3. Discount Rate PolicyDiscount Rate Policy -- The rate of interest -- The rate of interest depository institutions pay for borrowing from depository institutions pay for borrowing from the Fed.the Fed.

Raising the discount rate increases the cost Raising the discount rate increases the cost of borrowing for needed reserve balances.of borrowing for needed reserve balances.

Lowering the discount rate lowers the cost of Lowering the discount rate lowers the cost of bank liquidity and encourages lending and bank liquidity and encourages lending and money supply expansion.money supply expansion.

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Monetary Policy StrategyMonetary Policy Strategy

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An illustration of the transmission mechanism from interest rates to An illustration of the transmission mechanism from interest rates to pricesprices

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Two Pillars of ECB’s Monetary Policy StrategyTwo Pillars of ECB’s Monetary Policy Strategy

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First Pillar of ECB’s Monetary Policy Strategy: First Pillar of ECB’s Monetary Policy Strategy: Economic analysisEconomic analysis

1.1. The Economic AnalysisThe Economic Analysis focuses mainly on the assessment of current economic and financial developments and the implied short to medium-term risks to price stability. Includes:

Analysis of real economy indicators.

Analysis of financial market developments.

Analysis of exchange rate developments.

Euro area macroeconomic projections based on technical assumptions, models and technical expertise of staff

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Second Pillar of ECB’s Monetary Policy Strategy: Second Pillar of ECB’s Monetary Policy Strategy: Monetary analysisMonetary analysis

2. Monetary analysisMonetary analysis focuses on a longer-term horizon, exploiting the long-run link between money and prices. The monetary analysis mainly serves as a means of cross-checking, from a medium to long-term perspective, the short to medium-term indications for monetary policy coming from the economic analysis. Includes:

The analysis of special factors

A comprehensive assessment of liquidity and credit conditions

Analysis of components and counterparts of M3

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ConclusionConclusion There is no blueprint for the structure and There is no blueprint for the structure and

operations of a central bank. Although operations of a central bank. Although the structures of the Federal Reserve the structures of the Federal Reserve System and the Eurosystem are similar, System and the Eurosystem are similar, there are many differences in the way there are many differences in the way they operate.they operate.

The Eurosystem is more decentralized than the Federal Reserve.

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ConclusionConclusion

There is lesson for Fed to take from ECB:There is lesson for Fed to take from ECB:

To clarify the goals of monetary policy.To clarify the goals of monetary policy.

Disagreements remain over how to best make policy transparent while at the same time reserving the independence of the central banks.

Transparency of two FED and ECB has also increased.

It is harder for the ECB to forecast the monetary magnitude compared with the Fed due to the relatively limited data available from the past (only 5 years)

1 the european central bank (ecb) and the federal reserve (the fed): differences and similarities in...

Documents

federal reserve bank

european union

european community

european council

federal reserve act

bank panic

monetary policy slide

role of central bank