FNCE 3020 Financial Markets and Institutions Fall Semester 2006

1
FNCE 3020Financial Markets and Institutions
Fall Semester 2006

• Lecture 6
• Central Banking and the Conduct of Monetary
  Policy Impact on Financial Markets

2
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.

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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.

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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

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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

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Formal Structure of the Fed
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Importance of the Board of Governors
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The Twelve Federal Reserve Districts
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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.

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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

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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.

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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.

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Federal Funds Rate 1970 - Present
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Impact of Fed Funds Rate on Business Loan
Interest Rates (Prime Rate)
15
Impact of Fed Funds Rate on Money Market Interest
Rate (CD Rate)
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Impact of Fed Funds Rate on Long Term Corporate
Bond Rate (Aaa Rate)
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Impact of Fed Funds Rate on Mortgage Lending
Rate (30-Year Rate)
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Impact of Federal Funds Rate on Dollar
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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

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Central Bank Independence and Inflation, 1973-1988
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Central Bank Independence and Economic Growth,
1973-1988
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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.

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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.

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Inflation Targeting Examples

• The primary objective of the ECBs 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 Englands monetary policy objective
  is to deliver price stabilitydefined by the
  Governments 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 Switzerlands 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.

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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

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Worlds 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

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Other Useful Web Sites

• Links to all the worlds 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/

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Bank of England

• Founded in 1694 initially to manage the U.K.
  Governments 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 Banks 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.

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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.

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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.