Central Banking and the Federal Reserve System

Chapter 14 Central Banking and the Federal Reserve System Unit IV Central Banking, Monetary Policy, and the Federal Reserve System PowerPoint Presentation by Charlie CookThe University of West Alabama

Fundamental Issues • What were the first central banking institutions, and how did central banking initially develop in the United States? • Where did responsibilities for monetary and banking policies rest in the absence of a U.S. central bank in the nineteenth and early twentieth centuries? • What motivated Congress to establish the Federal Reserve System? • Why did Congress restructure the Federal Reserve in 1935? • Who makes the key policy decisions at the Federal Reserve? © 2006 Thomson Business and Professional Publishing. All rights reserved.

The Central Banking Experience • 1668 Swedish Sveriges Riksbank–the world’s first central bank • 1694 Bank of England established • 1701 Riksbank issues “transfer notes” • 1789 Riksbank issues Swedish currency • 1999 European Central Bank (ECB)–European System of Central Banks © 2006 Thomson Business and Professional Publishing. All rights reserved.

The Number of Central Banking Institutions, 1670 to the Present SOURCE: Forrest Capie, Charles Goodhart, and Norbert Schnadt, “The Development of Central Banking,” in Capie et al.,eds., The Future of Central Banking: The Tercentenary Symposium of the Bank of England (Cambridge: Cambridge University Press, 1994), pp.1–231, and authors’ estimates. © 2006 Thomson Business and Professional Publishing. All rights reserved. Figure 14–1

The Origins of U.S. Central Banking, 1791–1836 • Bank of England • Bank of the British Empire and a model for U.S. banking system • The Bank of North America (1781) • Robert Morris and the first nationally charted (government licensed) bank: not really a central bank however • The First Bank of the United States (1791): had only a 20 year charter © 2006 Thomson Business and Professional Publishing. All rights reserved.

The Origins of U.S. Central Banking, • The Second Bank of the United States (1816): closed by Andrew Jackson in 1836. • No real central bank from 1837-1912. The Treasury branch of government was therefore without a central financial agent to carry on government business. Thus they carried on business through state chartered banks, called their “pet banks.” © 2006 Thomson Business and Professional Publishing. All rights reserved.

Policy and Politics without a Central Bank, 1837–1912 (cont’d) • The free-banking period: • A period that lasted until the Civil War during which each state had its own banking rules, and many states permitted relatively open competition among banks. • The National Banking Act of 1863 established the first system of reserve requirements and encouraged the growth of demand deposits: laid the foundation for today’s Federal Reserve System. © 2006 Thomson Business and Professional Publishing. All rights reserved.

Policy and Politics without a Central Bank, 1837–1912 (cont’d) • Greenbacks had been issued by the government to fund the Civil war: were supposed to be removed after the war but many objected to decreasing the money supply. • The Panic of 1873 and resumption of the gold standard (1875) • Populism, free silver, and bimetalism • Free silver: A late-nineteenth-century idea for unlimited coinage of silver to meet the monetary needs of a growing U.S. economy. • Prelude to the federal reserve • Panics of 1893 and 1907 © 2006 Thomson Business and Professional Publishing. All rights reserved.

The Fed • After the panic of 1907, Congress passed the Aldrich-Breeland Act, which gave the Treasury emergency powers to issue currency in the event of a crisis. Also established a commission to develop a plan for a central bank. • This eventually led to the Federal Reserve Act of 1913. © 2006 Thomson Business and Professional Publishing. All rights reserved.

The Federal Reserve Banking System (the “FED”) • Originally, the Federal Reserve Board consisted of the Treasury secretary, the comptroller of the currency, and 5 others appointed by the president with Senate approval. (this would later be changed.) • Federal Reserve banks: • The twelve central banking institutions that oversee regional activities of the Federal Reserve System. © 2006 Thomson Business and Professional Publishing. All rights reserved.

The FED The Fed was originally charged with 3 tasks: • To develop and supervise the distribution of a national currency; to stand ready to supply in quantities necessary to help avert budding financial panics. • To establish a nationally coordinated system of check-clearing and collection services. • To process the federal government’s financial accounts and to serve as the central depository for government funds. © 2006 Thomson Business and Professional Publishing. All rights reserved.

The Early Fed, 1913–1935 • Two constraints in the early days: • 1. Very specific and limited ways of trying to avert financial panics: mostly could just loan to banks. Banks that wanted to borrow had to put up collateral in the form of discount bonds. The Fed would then buy these bonds at a further discount, called rediscounting. This added discount became known as the discount rate. • Discount rate: The rate of interest that the Federal Reserve charges to lend to a depository institution. © 2006 Thomson Business and Professional Publishing. All rights reserved.

The Early Fed, 1913–1935 • 2. Secondly, the Fed Act did not clearly define the distribution of powers within the Fed. • Specifically, the Fed Board did NOT have the power to dictate to the district banks, thus the regional banks often conducted their own policy. © 2006 Thomson Business and Professional Publishing. All rights reserved.

The hesitant Fed • At first, the Treasury secretary held much power, forcing the Fed to help finance the war effort in WW 1. • After the war, the power shifted to the 12 regional banks, especially the New York Fed whose president was Benjamin Strong. • Strong’s death in 1928 may have been very bad timing: no leading figure in the Fed at the beginning of the Great Depression to take charge. © 2006 Thomson Business and Professional Publishing. All rights reserved.

The Great Depression and reform of the Fed • Beginning of the depression, the Fed started to provide reserves to the system, but then backed off. • Did the Fed cause the Great Depression? Still a debated issue. • http://en.wikipedia.org/wiki/Causes_of_the_Great_Depression • At the very least, it appears that the Fed had failed in their first real financial crisis to be a “lender of last resort”. © 2006 Thomson Business and Professional Publishing. All rights reserved.

Reform of the Fed, 1930’s • Banking Act of 1935: Restructuring the Fed: Board of Governors no longer has the Treasury secretary or comptroller on it: all seven members are appointed by the President with Senate approval to 14 year terms in office. Also created the chair and vice chair jobs on the Fed board. • This law also created the FOMC, the Federal Open Market Committee, composed of the 7 governors and 5 of the regional bank presidents. Today this committee is the main policy arm of the system. © 2006 Thomson Business and Professional Publishing. All rights reserved.

Today’s Federal Reserve System • Federal Reserve districts: • The twelve geographic regions of the Fed. • Board of Governors of the Fed: • A group of seven individuals appointed by the president and confirmed by the Senate that, under the terms of the Banking Act of 1935, has key policymaking responsibilities within the Fed. • Federal Open Market Committee (FOMC): • A group composed of the seven governors and five of the twelve Fed bank presidents that determines how to conduct the Fed’s open market operations. © 2006 Thomson Business and Professional Publishing. All rights reserved.

The Evolution of the Modern Fed • The Fed’s fight for independence • Working for the U.S. Treasury: even after the Fed reforms of the 30’s, the Fed was still closely tied to the Treasury dept. especially during WW II, when the Treasury wanted to sell war bonds at low interest rates. The Fed would buy and sell securities in an effort to keep interest rates at a low level. © 2006 Thomson Business and Professional Publishing. All rights reserved.

The Evolution of the Modern Fed • The fight for Fed Independence • Federal Reserve–Treasury Accord: A 1951 agreement that dissociated the Fed from the policy of pegging Treasury bill rates at artificially low levels. Thus the Fed did not have to “monetize” the debt, which might create inflation. Since this accord, the Fed has been seen as quite the independent institution. © 2006 Thomson Business and Professional Publishing. All rights reserved.

The Evolution of the Modern Fed • “Leaning Against The Wind” • From 1953-1970, William McChesney Martin was the chairman of the Fed. He began the policy of “leaning against the wind.” Take money out of the economy to fight rising inflation, expand the money supply to fight deflation and a sluggish economy. • Free reserves: Total excess reserves at depository institutions minus the total amount of reserves that depository institutions have borrowed from the Fed. Martin tried to adjust Fed policy to keep free reserves fairly stable. © 2006 Thomson Business and Professional Publishing. All rights reserved.

The Evolution of the Modern Fed • Historically, often conflict between the Fed and other branches of government, such as Congress, the Treasury, or even the President. • Example in the book of the Vietnam War: again the president and Treasury pressured the Fed to try to keep interest rates low to help finance the war effort. © 2006 Thomson Business and Professional Publishing. All rights reserved.

The Evolution of the Modern Fed (cont’d) • The technocratic Fed • New Fed Chair in 1970, Arthur Burns. • Scientific approach to policymaking within the perspective of the likely effects on such aggregates as M1 and M2. • Federal funds rate become a widely recognized indicator of credit market conditions. • 1971: the end of the gold standard © 2006 Thomson Business and Professional Publishing. All rights reserved.

The Evolution of the Modern Fed • Inflation and monetary targeting • By the end of the 70’s, inflation was running quite high. Efforts to control interest rates, such as the Fed funds rate, were running into trouble. • William G. Miller became the Fed chairman briefly in 1978, followed by Paul Volcker. • Volcker instituted a policy of the Fed attempting to control monetary aggregates (the money supply) while de-emphasizing interest rate stability: this made interest rates more volatile yet slowed inflation. © 2006 Thomson Business and Professional Publishing. All rights reserved.

The Evolution of the Modern Fed (cont’d) • Today’s middle-of-the-road Fed • Since 1987, the Fed’s approach to conducting monetary policy is to attempt to stabilize the federal funds rate at a target value. • The Fed has been more successful in containing inflation in recent years, • In 1987 Alan Greenspan became chair of the Fed’s Board of Governors: just left in 2006, replaced by Ben Bernanke. Generally, Greenspans terms was seen as successful. • The manner in which policies are formulated and implemented continues to change. © 2006 Thomson Business and Professional Publishing. All rights reserved.

Organizational Structure of the Federal Reserve System SOURCE: Board of Governors of the Federal Reserve System. © 2006 Thomson Business and Professional Publishing. All rights reserved. Figure 14–4

Duties of the Fed • Board of Governors • Approve any discount rate changes • can set required reserve ratios • oversees the district banks • regulated financial holding companies • enforces the consumer protection laws discussed in ch. 12 © 2006 Thomson Business and Professional Publishing. All rights reserved.

Duties of the District Banks • The District Banks • Owned by their member banks • The member banks elect 6 of the nine board of directors of their Federal reserve bank, the other 3 appointed by the Feds Board of Governors • Processes checks and electronic payments • Replaces old currency • Lends money to member banks © 2006 Thomson Business and Professional Publishing. All rights reserved.

The FOMC • 12 members as noted earlier, meet 8-10 times a year. Determine the wording of the FOMC directive. • FOMC directive: • The official written instructions from the FOMC to the head of the Trading Desk at the Federal Reserve Bank of New York. • Trading Desk: • The Fed’s term for the office at the Federal Reserve Bank of New York that conducts open market operations on the Fed’s behalf. © 2006 Thomson Business and Professional Publishing. All rights reserved.

The Fed’s Independence • Why does this matter? • Recall the role of money and inflation: too much money can be inflationary. • Some economists argue that the Fed has tended to have an inflationary bias to it: puts too much money in the economy. • This was a major concern prior to Greenspans term. © 2006 Thomson Business and Professional Publishing. All rights reserved.

Annual Inflation Rates in the United States SOURCES: Economic Report of the President, 2005; Economic Indicators (various issues). © 2006 Thomson Business and Professional Publishing. All rights reserved. Figure 20–6

Central Bank Independence (ch. 20) • Study by Alesina and Summers, from Harvard, looked at an index of central bank independence and average rates of inflation as well as inflation variability. Results on next slide seem to indicate that more independent central banks have lower inflation and less variable inflation. © 2006 Thomson Business and Professional Publishing. All rights reserved.

Central Bank Independence, Average Inflation,and Inflation Variability in Major Developed Nations SOURCE: Alberto Alesina and Lawrence Summers, “Central Bank Independence and Macroeconomic Performance,” Journal of Money, Credit, and Banking (May 1993): 151–162. © 2006 Thomson Business and Professional Publishing. All rights reserved. Figure 20–7

Fed Independence • One possible problem however: does this lower inflation come at the expense of slower growth in real GDP? One study found little relationship. • However this topic is still far from resolved, and other studies are not so clear. © 2006 Thomson Business and Professional Publishing. All rights reserved.

Central Bank Independence, Average GDP Growth, and Variability of GDP Growth SOURCES: Carl Walsh, “Is There a Cost to Having an Independent Central Bank?” Federal Reserve Bank of San Francisco Weekly Letter, No.94-05, February 4, 1994. © 2006 Thomson Business and Professional Publishing. All rights reserved. Figure 20–8

Visit the Chicago Fed • http://www.chicagofed.org/ • Also visit the Fed 101 site: • http://www.federalreserveeducation.org/fed101/ © 2006 Thomson Business and Professional Publishing. All rights reserved.

Central Banking and the Federal Reserve System