FNCE 3020Financial Markets and Institutions Fall Semester 2006Lecture 6

Central Banking and the Conduct of Monetary Policy: Impact on Financial Markets

Why Study Central Banking? Central bank actions have significant impacts on

financial markets: (1) interest rates (the cost of borrowing and the return on

investing). (2) financial asset prices (stocks, bonds, foreign exchange)

Thus we need to know something about central banks: How central banks operate in financial markets How we might monitor the potential for changes in central

bank actions and thus attempt to predict future moves in (1) and (2) above.

Definitions of a Central Bank The following represent published definitions of

a central bank. Text book definition:

“The government agency that overseas the banking system and is responsible for the amount of money and credit supplied in the economy.”

Other definitions: “The major regulatory bank in a country.” “The government agency whose responsibilities

include: the issuance of currency, the administration of monetary policy, (e.g., open market

operations, the discount rate), and engaging in transactions designed to facilitate healthy

business interactions. (i.e., a sound financial system).” “A bank that acts as controller of credit.”

U.S. Central Bank: 1913 -

The Federal Reserve, the central bank of the United States, was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system.

http://www.federalreserve.gov/sitemap.htm

Formal Structure of the Federal Reserve System

The system (i.e., formal structure) as it exists now includes: Twelve Federal Reserve Banks Member Banks, i.e., members of the Federal Reserve

(around 3,600) Seven individuals who are members of the Board of

Governors (BOG) of the Federal Reserve System (including a Chairman).

Twelve individual members of the Federal Open Market Committee (FOMC).

Federal Advisory Council (12 bankers) Note: The system, however, is dominated by the Board of

Governors

Formal Structure of the Fed

Importance of the Board of Governors

The Twelve Federal Reserve Districts

Board of Governors and the FMOC The seven governors are appointed by the

President, and confirmed by the Senate, for 14-year terms on a rotating schedule.

All are members of the Federal Open Market Committee (FMOC): There are 12 members on the FOMC (7 are from

the Board of Governors) The chairman of the Board of Governors is also the

chair of the FOMC. The FOMC meets 8 times a year (about every 6

weeks), and: Makes a decision regarding the level of the federal

funds rate.

Policy Statements from the FOMC At the conclusion of each FOMC meeting, the FOMC will issue a

public statement which highlights the meeting. This statement will begin by stating what, if anything, the FOMC

has decided to do with the federal funds rate. This statement also reviews the current economic environment. This statement also provides opinions as to where the FOMC

sees the economy moving in the near term as well as noting any potential problem area (e.g., inflation, or specific sectors).

The statement will end with a review (breakdown) of the votes. As such, readers look for “clues” as the future outlook for monetary

policy. Will policy tighten, eased up, or stayed the course?

After three weeks, the FOMC will release the full minutes of its meeting. For a calendar of future meetings and past statements and full

minutes see: http://www.federalreserve.gov/fomc/#calendars

FOMC Press Release: August 8, 2006 The Federal Open Market Committee decided today to keep its target

for the federal funds rate at 5-1/4 percent. Economic growth has moderated from its quite strong pace earlier this

year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.

Readings on core inflation have been elevated in recent months, and the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures. However, inflation pressures seem likely to moderate over time, reflecting contained inflation expectations and the cumulative effects of monetary policy actions and other factors restraining aggregate demand.

Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Jack Guynn; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Kevin M. Warsh; and Janet L. Yellen. Voting against was Jeffrey M. Lacker, who preferred an increase of 25 basis points in the federal funds rate target at this meeting.

Importance of the Federal Funds Rate The federal funds rate is the interest rate at which

depository institutions lend reserve balances through the Federal Reserve system to other depository institutions

These reserve loans are essentially on an overnight basis.

Why is the federal funds rate important? Because changes in the federal funds rate trigger a chain

of events that affect: The amount of money and credit in the economy (via lending

activities) Other short-term (money market) interest rates, Long-term interest rates, Foreign exchange rates, and, Ultimately, a range of economic variables, including

employment, output, and prices of goods and services.

Federal Funds Rate: 1970 - Present

Impact of Fed Funds Rate on Business Loan Interest Rates (Prime Rate)

Impact of Fed Funds Rate on Money Market Interest Rate (CD Rate)

Impact of Fed Funds Rate on Long Term Corporate Bond Rate (Aaa Rate)

Impact of Fed Funds Rate on Mortgage Lending Rate (30-Year Rate)

Impact of Federal Funds Rate on Dollar

Should Central Banks be Independent? Traditionally, most central banks were “agents” of

their respective governments. In recent years, however, there has been growing

debate as to the wisdom of this arrangement. Case for Central Bank Independence:

Independent Central Bank is likely to have longer run objectives while politicians may not.

Empirical work suggests that countries with the most independent central banks do the best job of controlling inflation (see next slide).

Avoids political business cycle Case against Central Bank Independence

Central Bank may not be accountable Hinders coordination of monetary and fiscal policy

Central Bank Independence and Inflation, 1973-1988

Central Bank Independence and Economic Growth, 1973-1988

Major Central Banks Independence All of the major central banks, and many lesser central banks, currently operate as independent central banks.

Central Bank Date of Independence* Federal Reserve: 1913 Bank of England: 1997 Bank of Japan: 1998 European Central Bank: 1999**

*Date of separation from government influence. **ECB independence granted in original charter.

Transparency and Inflation Targeting Transparency means that a central bank provides

the general public and the markets with all relevant information on its strategy (i.e., targets), economic assessments and policy decisions as well as its procedures in an open, clear and timely manner.

Today, most central banks consider transparency as crucial to their success. Many Central Bank web site now in English. Central Bank decisions and actions are published in a

timely and open manner. Additionally, inflation targeting has become

accepted as the proper economic goal for many central banks. Targeting refers to central banks publishing their inflation

goals and adjusting their policies to meet these goals.

Inflation Targeting Examples “The primary objective of the ECB’s monetary policy is to

maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.”

“The Bank of England’s monetary policy objective is to deliver price stability…defined by the Government’s inflation target of 2%.”

“Bank of Korea has adopted inflation targeting and its current inflation target has been set for the period 2004-2006 as a range of 2.5-3.5%.”

“The Central Bank of Iceland's main objective is price stability, defined as a 12-month rise in the CPI (Consumer Price Index) of 2½%.”

“The Bank of Switzerland’s monetary policy aims at ensuring price stability in the medium and long term; price stability is defined as a rise in the national consumer price index (CPI) of less than 2% per annum.

What About the Federal Reserve?“The goals of monetary policy are spelled out in the

Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Market Committee should seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

Note: there is nothing in this statement that refers to specific inflation targets.

http://www.federalreserve.gov/pf/pdf/pf_2.pdf

World’s Major Central Bankers United States: Ben Bernanke http://www.federalreserve.gov/

European Union: Jean-Claude Trichet http://www.ecb.int/

Bank of England: Mervyn King http://www.bankofengland.co.uk/

Bank of Japan: Toshihiko Fukui http://www.boj.or.jp/en/index.htm

Other Useful Web Sites

Links to all the world’s Central Banks http://www.bis.org/cbanks.htm

Federal Reserve statistical data http://www.federalreserve.gov/releases/

Economic time series, U.S. and some foreign (also allowing for graphing of data) http://www.economagic.com/

Bank of England Founded in 1694 initially to manage the U.K.

Government’s accounts and to borrow on behalf of the Government (usually to finance wars).

Controlled by the Government until granted “interest rate” autonomy in 1997 by the Labor Party.

Since May 1997 the Bank’s 9 member Monetary Policy Committee has had statutory responsibility for setting interest rates to meet the Government's stated inflation target. Each year the Chancellor of the Exchequer sets an inflation

target for the country (currently 2%). The MPC has to judge what interest rate it necessary to meet

that inflation target. The Bank implements its interest rate decisions by setting the

interest rate at which the Bank lends to commercial banks and other financial institutions in the U.K.

Bank of Japan (Nippon Ginko) Founded in 1882. The Bank of Japan Law (1998) gave the Bank of Japan

autonomy for monetary policy. Also stated that monetary control shall pursuit price stability.

The 7 member Policy Board targets an overnight interest rate for “uncollateralized call money” (similar to U.S. federal funds).

The Bank controls the call money rate on a daily basis through money market operations (similar to open market operations). Also uses an official discount rate at which it will make loans to

banks.

European Central Bank (ECB) Founded in January 1999 by a treaty between the

European Central Bank (ECB) and the European System of Central Banks (ESCB). Stated goal is to maintain price stability in the euro area (at

inflation rates of below, but close to, 2% over the medium term). The 18 member Governing Council is the main decision

making body of the ECB. Consist of 6 Executive Board Members (chosen by the 12 euro

member governments) plus the 12 governors of all the national central banks from the 12 euro area countries

The Governing Council meets its inflation target by setting the interest rate at which banks borrow from the central bank (similar to U.S. federal funds rate). The key ECB rate is the interest rate on “refinancing operations”

which provide the bulk of liquidity to the banking system.