Unit 6

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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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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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 (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 5,000 commercial banks are members)

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Member Banks

https://www.federalreserve.gov/releases/lbr/current/default.htm

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Member Banks

https://www.federalreserve.gov/releases/lbr/current/default.htm

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Member Banks

• 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
• Chairperson is chosen from the governors and serves four-year term

https://www.federalreserve.gov/aboutthefed/bios/board/default.htm

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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

Feb 2014 –

Feb 2018

Feb 2006 –

Jan 2014

Aug 1987 –

Jan 2006

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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
• Chairperson 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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The Chair 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.

https://www.federalreserve.gov/monetarypolicy/fomc.htm

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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

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• The president appoints Chair 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.

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

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• 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

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