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Chapter 16 – The Structure of Central Banks: The Federal Reserve and the European Central Bank

Chapter 16

The Structure of Central Banks:

The Federal Reserve and the European Central Bank

Chapter Overview

In this chapter we examine two important central banks, the U.S. Federal Reserve System

and the European Central Bank, and see how their structure helps them to meet their

objectives.

Learning Objectives: Establish an understanding of:

1. The structure of the Federal Reserve System

2. The effectiveness of the Federal Reserve System

3. The structure of the Eurosystem

4. The euro‐area crisis and the ECB

Important Points of the Chapter

The instability and chaos that accompany financial panics damage more than just the

banks that are directly involved; everyone is slow to regain confidence in the financial

system after a panic, making it hard for anyone to obtain financing. The more frequent

the panics the worse the situation gets, and the slower the economy grows. The

punishing effects of frequent financial panics led people to reconsider the merits of a

powerful central bank. For Europe in the 20th century, however, central banking was not

enough, and leaders came to believe that the only way to ensure both political and

economic stability was to forge closer ties among the continent’s countries. This led to

the European monetary union, with its common currency (the euro) and its central bank

(the European Central Bank, or ECB).

Application of Core Principles

Principle #5: Stability. The Board of Directors of each Federal Reserve Bank is made up

of bankers but also of business leaders and others that represent the public interest.

Though the range of views represented is wide, everyone has an interest in ensuring

economic and financial stability.

Principle #3: Information. The FOMC releases huge amounts of information to the

public, but lots of information isn’t always the right information. There is no regular

press conference or questioning of the Chair on the FOMC’s current policy stance and

some information is released at varying amounts of time after the meeting.

Principle #5: Stability. Fed officials state that they strive to attain “price stability and

maximum sustainable economic growth” but do not specify what is meant by either term.

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Principle #3: Information. Like the Federal Reserve, the ECB distributes large volumes

of information, both on paper and on its website, but the most important aspect of the

ECB’s communication strategy concerns statements about the Governing Council’s

policy deliberations. Unlike the FOMC there is a press conference and transcripts are

made immediately available.

Principle #5: Stability. The Treaty of Maastricht states that the primary objective of the

ECB is to maintain price stability. As with the Fed’s legislatively dictated objectives, the

statement is vague.

Teaching Tips/Student Stumbling Blocks

If you have the equipment to do so, you can put some names and faces to the

text’s references to the FOMC. Visit its web site at

http://www.federalreserve.gov/FOMC/ and scroll down to the bottom of the page.

You’ll find a listing of the members and links to their photos and bios.

You may find members of the European Central Bank’s Governing Council at

http://www.ecb.int/ecb/orga/decisions/govc/html/index.en.html.

Features in this Chapter

Your Financial World: Treasury Direct

Treasury Direct lets you buy as little as $1,000 worth of Treasury securities without

paying any broker fees; all you need to do is fill out a few forms, write a check, and send

them in. And that’s only for the first time; afterwards you can make purchases

electronically. Since the securities are sold by bid, purchasers place a noncompetitive

bid, which means that they will receive the bond they want at the average auction price.

Tools of the Trade: Decoding the FOMC Statement

Following every meeting, the FOMC issues a press release announcing its policy

decision. As the financial crisis deepened in 2008, the form of the statement changed

markedly. A typical statement continues to include the current target for the federal funds

rate, provides a brief synopsis of the Committee’s views of current conditions, and a

report of the vote. The statement tells us about the current state of the economy and

indicates what the FOMC’s near term policy actions will likely be, and indicating what

will trigger the next move. The statement also includes a description of the policy tools

that the Fed will use to achieve its objectives.

Applying the Concept: The Evolution of Federal Reserve Independence

In 1935, the Secretary of the Treasury and the Comptroller of the Currency were removed

from the Federal Reserve Board and the FOMC was created. The Fed lost some of its

independence during World War II, when maintaining low interest rates for the war effort

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become a priority, but this was regained in the 1950s. Of course, the FOMC’s ability to

do its job still depends on the willingness of politicians to refrain from interference.

Fortunately, in recent years, politicians have been supportive of the Fed, both its

day-to-day policies and its institutional structure.

Your Financial World: The Fed Can’t Save You from a Stock Market Crash

In the late 1990s many investors came to believe that the Fed would not let the stock

market decline significantly because such a decline would reduce spending, sending the

economy into a recession. As a result, stocks were perceived as being less risky, and the

risk premium became smaller, driving prices up even further. But the Fed doesn’t control

the stock market, and the market did decline in 2001 and 2002. No one can eliminate the

risk that is inherent in an investment—not even the most powerful central bank in the

world.

In the News: Should the Fed Change its Target?: Interview with Michael Woodford

Michael Woodford is a Columbia University economist who is widely viewed as one of

the world’s foremost experts on monetary policy. In September, 2012, he wrote that

central banks should focus on a target level of economic growth rather than just inflation.

The interview discusses this viewpoint, which he states is a refinement of current policy

targeting.

Lessons of the Article: Targeting nominal GDP (NGDP) is an alternative to

inflation targeting. When NGDP stayed far below its pre‐2007 trend in many

countries after the financial crisis, advocates argued that NGDP targeting would

speed economic recovery by influencing private expectations. However, if the trend

rate of growth changes, inflation becomes unpredictable under NGDP targeting. As

of early 2013, no country has adopted NGDP targeting, but the Fed’s announced

policy thresholds for unemployment and inflation also aim at speeding recovery by

influencing future expectations.

Lessons from the Crisis: The ECB and the Crisis of the Euro Area

Even an independent central bank cannot secure price stability over the long term if fiscal

policymakers do not control the rise of public debt. The authors of the Maastricht Treaty

designed no credible institutions to provide for fiscal and financial stability in the euro

area. When the euro-area crisis began, policy makers had to quickly respond to keep the

monetary union from breaking up. The actions of fiscal policy makers and prudential

regulators in the 17 member countries of the euro area had spillover effects on other

countries in the monetary union. If one country’s debt had been purchased by banks

throughout the monetary union, default would render banks in other parts of the union

insolvent. Further, if banks become insolvent, the need to insure their deposits and

recapitalize them can render the governments insolvent, as well.

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Additional Teaching Tools

In a speech, found at http://www.ecb.int/press/key/date/2010/html/sp100618.en.html

entitled “Central Banks and Development of the World Economy: New Challenges and a

Look Ahead” given at the 150th Anniversary of the Central Bank of the Russian

Federation High-Level International Conference, Moscow,18 June 2010, Jean-Claude

Trichet, President of the ECB discusses the lessons learned in the financial crisis of

2007-2009.

Virtual Tools

Visit the Federal Reserve on the web at:

http://www.federalreserve.gov

Visit the European Central Bank on the web at:

http://www.ecb.int/home/html/index.en.html

Visit the Bank of England on the web at:

http://www.bankofengland.co.uk/Pages/home.aspx

For More Discussion

We can turn on C-SPAN and watch Congress debate important issues that will affect our

lives. But the FOMC meets in secret, making decisions that are arguably critical to our

financial lives. Is the FOMC fundamentally undemocratic? Should its operations be

changed?

Chapter Outline

I. The Structure of the Federal Reserve System

1. The Federal Reserve Act, passed in 1913 and amended several times since

then, establishes a system that is composed of three branches with overlapping

responsibilities.

2. There is are the twelve regional Federal Reserve Banks, distributed

throughout the country; a central governmental agency, the Board of

Governors, located in Washington, D.C.; and the Federal Open Market

Committee.

3. In addition, a series of advisory committees makes recommendations to the

Board and the regional Banks.

4. Finally, there are the commercial banks that are members of the system.

5. This complex structure diffuses power in a way that is typical of the U.S.

government, creating a system of checks and balances that reduces the

tendency for power to concentrate at the center.

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6. All national banks (chartered by the federal government) are required to

belong to the Federal Reserve System, and state banks have the option to join

(though less than 20 percent do because of the cost involved).

7. Members and nonmembers alike must hold non-interest bearing reserve

deposits at the Fed, so there is no real distinction between them.

The Federal Reserve Banks

1. The Federal Reserve Bank of New York is the largest of the twelve regional

Federal Reserve Banks.

2. The geographical lines that define the Banks’ districts were drawn in 1914 and

represent the population density at the time and the decision that no district

should coincide with a single state.

3. This arrangement has two purposes: to ensure that every district contains as

broad a mixture of economic interests as possible and that no person or group

can obtain preferential treatment from the Reserve Bank.

4. Reserve Banks are part public and part private; they are owned by the

commercial banks in their districts and are overseen by the Board of

Governors.

5. The Board of Directors of each bank is comprised of representatives of

banking, other business leaders, and those who represent the public interest.

Of the nine members on each board, six are elected by the commercial bank

members and three are appointed by the Board of Governors.

6. Each Reserve Bank has a President who is appointed for a five-year term by

the Bank’s Board of Directors (with the approval of the Board of Governors).

7. The Reserve Banks conduct the day-to-day business of the central bank,

serving as both the government’s bank and the bankers’ bank.

8. As the bank for the U.S. government they issue new currency, maintain the

U.S. Treasury’s bank account, and manage the U.S. Treasury’s borrowings.

9. As the bankers’ bank they hold deposits for the banks in their districts, operate

and ensure the integrity of a payments network, make funds available to

commercial banks in the district through “discount loans,” supervise and

regulate financial institutions in the district, and collect and make data

available on business conditions.

10. In addition to these duties the Federal Reserve Bank of New York provides

services to foreign central banks and to certain international organizations that

hold accounts there; it is also the System’s point of contact with financial

markets.

11. Finally, the Reserve Banks play an important part in formulating monetary

policy, both through their responsibilities on the FOMC and through their

participation in setting the discount rate.

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A. The Board of Governors

1. The seven members of the Board are appointed by the President and

confirmed by the U.S. Senate for 14-year terms, which are staggered

(typically one new member is appointed every two years).

2. These long terms are intended to protect the Board from political pressure, as

is the fact that the terms are staggered so that one begins every two years.

3. The Board has a Chairman and two vice chairmen, appointed by the President

from among the seven governors for four-year renewable terms.

4. The duties of the Board are to: set the reserve requirement, approve or

disapprove the discount rate recommendations made by the Federal Reserve

Banks, rule-writing for consumer credit protection laws, approve bank

mergers, supervise and regulate the regional Reserve Banks, regulate and

supervise the banking system (along with the Reserve Banks), invoke

emergency powers to lend to nonbanks when circumstances are deemed

“unusual and Exigent,” analyze financial and economic conditions, and collect

and publish statistics about the system’s activities and the economy at large.

B. The Federal Open Market Committee

1. The FOMC is the group that sets interest rates to control the availability of

money and credit to the economy.

2. Made up of the seven Governors, the President of the NY Fed, and a rotating

selection of four of the remaining 11 Reserve Bank Presidents, it is chaired by

the Chairman of the Board of Governors.

3. The FOMC controls the federal funds rate, the rate banks charge each other on

overnight loans of excess deposits at the Fed.

4. The FOMC meets eight times a year, although in extraordinary times it can

meet more often.

5. The primary purpose of a meeting is to decide on the target interest rate and

produce a policy directive, which tells the NY Fed how to conduct purchases

and sales of Treasury securities in order to meet the FOMC’s goals.

6. Prior to each meeting participants receive the beige book (a compilation of

anecdotal information about current business activity) and the Tealbook

(containing the board staff’s economic forecast for the next few years and a

discussion of financial markets and current policy options).

7. An FOMC meeting is a formal proceeding that can be divided into two parts

each beginning with reports by the staff and containing rounds of discussion

by the meeting participants.

8. Reports by the staff include presentations by the System Open Market

Account Manager (reporting on financial market conditions and actions taken

to achieve the target interest rate since the last meeting); the Senior staff of the

Board comment on the economic situation and financial developments; and

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the Director of the Division of Research and Statistics at the Federal Reserve

Board (presenting the staff’s forecast from the green book).

9. The ensuing round of discussion is called the economic go-round. One at a

time committee members describe their view of the economic outlook, and

then the Chair speaks at the end.

10. Next, the Director of Monetary Affairs describes the policy options (from the

blue book). Committee members again comment on the options, with the

Chair speaking last.

11. Finally there is a vote taken, with the Chair voting first, the Vice Chair

second, and then the committee members (in alphabetical order).

12. The Chair of the Federal Reserve is the FOMC’s most powerful member; to

have an impact on policy, governors or Reserve Bank presidents must build

support for their positions through their statements at the meeting and in

public speeches.

13. However, while the Chair is very powerful, the committee structure does

provide an important check on that person’s power.

II. Assessing the Federal Reserve System’s Structure

A. Independence from Political Influence

1. The Fed controls its own budget, which is an important criterion for central

bank independence.

2. The Fed does occasionally come under political attack, especially when it

believes it must raise interest rates.

3. The Dodd-Frnak Act of 2010 curtailed the Fed’s emergency lending powers

and required new disclosures of Fed transactions, but it also widened Fed

supervisory responsibility.

B. Decision Making by Committee

1. The Fed meets this criterion for independence because the FOMC is a

committee.

2. The chair may dominate policy decisions, but the fact that there are 12 voting

members provides an important safeguard against arbitrary action by a single

individual.

C. Accountability and Transparency

1. The FOMC releases huge amounts of information to the public.

2. A brief policy statement is released within a couple of hours of adjournment

of the meeting. Three weeks later, the committee publishes the minutes of the

meeting which states how each member voted (including reasons for

dissention). After five years, the FOMC publishes transcripts of the meeting,

along with the Tealbook.

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3. The Committee’s refusal to state its objectives clearly and concisely hampers

communication. The shift to an inflation-targeting strategy should facilitate

communications.

D. Policy Framework

1. The Congress of the United States has set the Fed’s objectives, but the

statement is vague enough that the Fed can essentially set its own goals.

2. The FOMC’s approach is largely transparent today, and the strategy is

consistent with the inflation-targeting framework.

3. The FOMC statement of principles quantifies the inflation objective over the

longer term.

III. The European Central Bank

A. Organizational Structure

1. The Eurosystem mirrors the structure of the Federal Reserve in that there is an

Executive Board (like the Board of Governors), the National Central Banks

(like the regional Federal Reserve Banks) and the Governing Council (which,

like the FOMC, formulates monetary policy).

2. The Executive Board has a President and Vice President who play the same

role as the Chairman and Vice Chairman of the Fed.

3. The ECB and the NCBs together perform the traditional operational functions

of a central bank; they use interest rates to control the availability of money

and credit in the economy, are responsible for the smooth operation of the

payments system, and issue currency.

4. The NCBs continue to serve as bankers to the banks and governments in their

countries.

5. Unlike the Fed, the ECB does not supervise and regulate financial institutions.

Also, the implementation of monetary policy is not centralized and the ECB’s

budget is controlled by the NCBs and not vice versa.

6. The focus of the ECB’s activity is on the control of money and credit in the

Eurosystem.

7. The Governing Council meets monthly and decisions are made by consensus;

occasionally votes do occur.

8. The ECB’s independence is protected by long terms of office, the fact that the

ECB’s financial interest must remain separate from any policy organization,

and by the provision in the Treaty of Masstricht that the Governing Council

cannot take instructions from any government.

9. As the number of members in the Eurosystem has increased, the Governing

Council has adopted a rotating system for voting like that used by the FOMC.

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B. Accountability and Transparency

1. The most important aspect of the ECB’s communication strategy concerns

statements about the Governing Council’s policy deliberations; unlike the

FOMC there is a news conference at which questions are taken and the

transcript is posted on the website immediately.

2. The primary problem with ECB communications is that there often are a

number of conflicting opinions expressed.

3. But indications are that the system is working and that there is accountability.

C. The Price Stability Objective and Monetary Policy Strategy

1. The Treaty of Maastricht states that the primary objective of the ECB is to

maintain price stability.

2. The ECB’s strategy has been to numerically define price stability and to focus

on a broad-based assessment of the outlook for future prices, with money

playing a prominent role.

3. Price stability is defined as inflation of close to 2 percent, based on a

euro-area wide measure of consumer prices called the Harmonized Index of

Consumer Prices (similar to the U.S. CPI).

4. The economically large countries matter much more than the small ones,

which affects the dynamics of the Governing Council’s policy making.

5. However, evidence suggests that the ECB is doing the job it is supposed to do.

Terms Introduced in Chapter 16

Board of Governors of the Federal Reserve System

discount rate

emergency powers

euro area

European Central Bank (ECB)

European System of Central Banks (ESCB)

Eurosystem

Executive Board of the ECB

federal funds rate

Federal Open Market Committee (FOMC)

Federal Reserve Banks

Federal Reserve System

FOMC Statement

Forward guidance

Governing Council of the ECB

Inflation targeting

National Central Banks (NCBs)

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Using FRED: Codes for Data in This Chapter

Data Series FRED Data Code

Federal funds rate FEDFUNDS

Discount rate (Primary Credit) DPCREDIT

Personal consumption expenditures price index PCEPI

Harmonized index of consumer prices CP0000EZ17M086NEST

France gross sovereign debt (percent of GDP) GGGDTAFRA188N

Germany gross sovereign debt (percent of GDP) GGGDTADEA188N

Italy gross sovereign debt (percent of GDP) GGGDTAITA188N

Japan gross sovereign debt (percent of GDP) GGGDTAJPA188N

Spain gross sovereign debt (percent of GDP) GGGDTAESA188N

US gross sovereign debt (percent of GDP) GGGDTAUSA188N

Lessons of Chapter 16

1. The Federal Reserve System is the central bank of the United States. Its

decentralized structure comprises three primary elements:

a. Twelve Federal Reserve Banks, each with its own Board of Directors, that:

i. Serve as the government’s bank, issuing currency, maintaining the

U.S. Treasury’s bank account, and handling the Treasury’s securities.

ii. Serve as the bankers’ bank, holding deposits, operating a payments

system, making loans, and evaluating the safety and soundness of

financial institutions in their districts.

b. The seven-member Board of Governors in Washington, D.C., including

the chair

i. Regulates and supervises the financial system.

ii. Oversees the Federal Reserve Banks.

iii. Publishes economic data.

c. The Federal Open Market Committee

i. Makes monetary policy by setting interest rates.

ii. Has 12 voting members, including the 7 Governors and 5 of the 12

Reserve Bank Presidents.

iii. Meets 8 times a year.

iv. Is controlled largely by the chair.

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2. The FOMC’s success in meeting its objectives is enhanced by

a. Its independence, which comes from its members’ long

terms, budgetary autonomy, and the irreversibility of its policy decisions.

b. Clear communication of its policy decisions through an

explanatory statement that is distributed immediately and minutes that are

published following the next meeting.

c. Regular public appearances of the committee’s members.

It is impaired by:

a. Its unwillingness to define exactly what is meant by the stated goals of price

stability and sustainable economic growth.

b. Its unwillingness to respond to questions about its policy stance in a timely

manner.

3. The European Central Bank (ECB) is the central bank for the countries that

participate in the European monetary union—the euro area.

a. The Eurosystem is composed of three distinct parts:

i. The National Central Banks (NCBs) provide services to the banks and

governments in their countries.

ii. The European Central Bank in Frankfurt, with its six-member Executive

Board, which oversees the monetary system.

iii. The Governing Council, which makes monetary policy decisions.

b. The ECB’s primary objective is to stabilize prices in the common currency

area.

c. The ECB’s success in meeting its policy objectives is aided by the timely

announcement of policy decisions, press conferences in which top ECB

officials respond to questions, and the release of twice-yearly forecasts.

d. The ECB’s transparency is impaired by the fact that the minutes of its policy

meetings are not published for 20 years.

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