Central Banks, the Fed, and Monetary Policy

Professor Wayne Carroll

Department of Economics

University of Wisconsin-Eau Claire

carrolwd@uwec.edu

Slides available at www.uwec.edu/carrolwd

Central Banks

Bank of Japan Bank of England

European Central Bank

People’s Bank of China

Federal Reserve System

Good sources: Bank for International Settlements website:

http://www.bis.org/

Links to central bank websites:

http://www.bis.org/cbanks.htm

Central Banks

The Federal Reserve System

“The Fed” Central bank for the U.S. Roles:

Conducts monetary policy (controls the nation’s money supply)

One of the agencies that regulates the banking system

“lender of last resort” Facilitates payments (issues currency, clears

checks)

The Federal Reserve System

The Fed is directed by: Board of Governors

7 members appointed by the President and approved by Congress

Federal Open Market Committee (FOMC) 12 members, including the Board of

Governors and five other Fed officials Chair serves as chairman of both committees

The Federal Reserve System

Alan Greenspan – Chair, 1987 - 2006

Ben Bernanke –

Chair, 2006 - ?

The Federal Reserve System

The Board of Governors meets in Washington, D.C.

The Fed includes 12 regional Federal Reserve Banks

Some Federal Reserve Banks

New York FedMinneapolis Fed

Atlanta

Fed

Some Federal Reserve Banks

The Fed’s Balance Sheet(billions of dollars, as of December 20, 2006)

AssetsU.S. government securities 811.1

Discount loans 0.2

Gold and SDR accounts 13.2

Other Federal Reserve assets 44.4

Total 868.9

LiabilitiesFederal Reserve notes 775.9

outstanding

Bank deposits (reserves) 16.5

U.S. Treasury deposit 5.4

Other liabilities 40.7

CapitalSurplus 30.4

Total 868.9

The Fed and the U.S. Government

The Fed was created to be very independent.Not really part of the federal government Not directed or controlled by the President,

Congress, or any government agencyFed decisions are made by the Board of

Governors and other Fed officials

The President and members of Congress respect the Fed’s independence.

The Fed and the U.S. Government

Factors that make the Fed more independent: Not funded by Congress Members of the Board of Governors have long (14-

year) terms

Factors that make the Fed less independent: The Fed was created by Congress, so Congress can

pass legislation that changes the Fed’s structure, procedures, or policies

The President appoints members of the Board of Governors, and they are approved by Congress

Central Bank Independence

Economists and policy makers believe that it’s important for a central bank to be independent from the government.

Many countries have granted more independence to their central banks in the last fifteen years.

Central Bank Independence

Why is an independent central bank better? An independent central bank is more likely to

follow low-inflation policies.

Evidence suggests that in the long run a central bank can only control the rate of inflation (not the economic growth rate).

The government tends to push for policies that promote faster economic growth in the short run. If the central bank is independent, it can say “No.”

Central Bank Independence and Inflation: Early Evidence

Central Bank Independence and Inflation: Recent Evidence

Charles T. Carlstrom and Timothy S. Fuerst, “Central Bank Independence: The Key to Price Stability?” Federal Reserve Bank of Cleveland, September 1, 2006.

Macroeconomic Goals of the Fed

According to the U.S. Congress, the Fed should seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

These goals are often in conflict.

The Fed must choose the best balance.

The Fed’s Monetary Policy Tools

“Monetary policy” refers to changes in the nation’s money supply brought about by the Fed.

“Monetary policy tools” are actions the Fed can take to alter the money supply.

Open-Market Operations – the Fed’s purchases and sales of government bonds for its own portfolio.

Open-Market Operations

An open-market purchase causes the nation’s money supply to increase.

Public The Fed

bonds

$$$

Open-Market Operations

Open-market operations take place “on the open market,” not through transactions with the U.S. Treasury or directly with banks.

Controlled by the Federal Open-Market Committee (FOMC).

The FOMC meets every six weeks to consider policy changes.

Federal Funds Rate Target

The FOMC formulates its monetary policy in terms of a target level for the federal funds rate.

federal funds rate: the interest rate banks charge each other

when they borrow and lend reserves.

Federal Funds Rate Target

Banks set the federal funds rate, but the Fed uses open-market operations to control it.

Open-market purchase:The Fed buys government bonds.Sellers of the bonds deposit the funds in banks, so bank reserves increase.Banks have more reserves, so they choose to set the federal funds rate lower.

Similarly, an open-market sale tends to raise the federal funds rate.

Federal Funds Rate Target

So the Fed sets a target level for the federal funds rate, and then uses open-market operations to hit the target.

A lower target: The Fed buys more bonds, and makes the money supply increase more.This tends to make the economy grow faster in the short run.

Therefore the Fed reduces the federal funds rate target in a recession.

Federal Funds Rate Target

A higher target: The Fed buys fewer bonds (or sells some of its bonds), so the money supply increases slowly (or falls).This tends to slow the economy in the short run.

The Fed uses this policy when it wants to fight inflation.

Federal Funds Rate Since 1990

0%

1%

2%

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9%

10%

1990 1995 2000 2005

Federal Funds Rate Since 1990

0%

1%

2%

3%

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9%

10%

1990 1995 2000 2005

recessions

The Fed’s Monetary Policy

During a recession the Fed: Reduces the federal funds target rate Makes the money supply grow faster Makes the economy grow faster in the short

runAfter a recession the Fed: Raises the federal funds rate to prevent an

increase in the inflation rate Makes the money supply grow more slowly Slows the nation’s economic growth in the

short run

Monetary Policy Strategy

Any central bank’s monetary policy aims at a nominal anchor target.

Choices: Exchange rate Inflation rate Money supply

Targeting a nominal anchor keeps the central bank focused on low inflation in the long run.

Exchange-Rate Targeting

The central bank fixes the value of its currency to the dollar (or some other major currency).

The central bank gives up its independent monetary policy powers.

Two interesting options: Currency board (as in Hong Kong) Dollarization (as in Ecuador)

Inflation Targeting

The central bank: announces a target range for the inflation rate

(perhaps 1% to 2%) commits itself to following a monetary policy

that hits the target

Inflation targeting makes it easier for the central bank to follow a low-inflation policy in the long run.

The Fed’s Monetary Policy Strategy

The Fed uses an “implicit nominal anchor” – an informal long-run inflation target.

The Fed’s policy has generally been successful.

Disadvantages: Fed officials have a lot of discretion (or power

to choose their policy independently) – too much?

The Fed’s policies would be more credible and transparent if the inflation target were formal.

The Fed’s Monetary Policy Strategy

Ben Bernanke is a strong advocate of a more formal inflation target.

The Fed might move slowly toward a greater reliance on inflation targeting.