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Part IV Central Banking and the Conduct of Monetary Policy Ch a p ter 14 PREVIEW Structure of Central Banks and the Federal Reserve System Among the most important players in financial markets throughout the world are central banks, the government authorities in charge of monetary policy. Central banks’ actions affect interest rates, the amount of credit, and the money supply, all of which have direct impacts not only on financial markets, but also on aggregate output and inflation. To understand the role that central banks play in financial markets and the overall economy, we need to understand how these organizations work. Who controls central banks and determines their actions? What motivates their behavior? Who holds the reins of power? In this chapter, we look at the institutional structure of major central banks, and focus particularly on the Federal Reserve System, the most important central bank in the world. We start by focusing on the formal institutional structure of the Fed and then examine the more relevant informal structure that determines where the true power within the Federal Reserve System lies. By understanding who makes the decisions, we will have a better idea of how they are made. We then look at several other major central banks and see how they are organized. With this information, we will be more able to comprehend the actual conduct of monetary policy described in the following chapters. Origins of the Federal Reserve System Of all the central banks in the world, the Federal Reserve System probably has the most unusual structure. To understand why this structure arose, we must go back to before 1913, when the Federal Reserve System was created. Before the twentieth century, a major characteristic of American politics was the fear of centralized power, as seen in the checks and balances of the Constitution and the preservation of states’ rights. This fear of centralized power was one source of the American resistance to the establishment of a central bank (see Chapter 10). Another source was the traditional American distrust of moneyed interests, the most prominent symbol of which was a central bank. The open hostility of the American public to the existence of a central bank resulted in the demise of the first two experiments in central banking, whose function was to police the banking system: The First Bank of the United States was disbanded in 1811, and the national charter of the Second 335 336 PART IV Central Banking and the Conduct of Monetary Policy Box 1: Inside the Fed The Political Genius of the Founders of the Federal Reserve System The history of the United States has been one of public hostility to banks and especially to a central bank. How were the politicians who founded the Federal Reserve able to design a system that has become one of the most prestigious institutions in the United States? The answer is that the founders recognized that if power was too concentrated in either Washington or New York, cities that Americans often love to hate, an American central bank might not have enough public support to operate effectively. They thus decided to set up a decentralized system with 12 Federal Reserve banks spread throughout the country to make sure that all regions of the country were represented in monetary policy deliberations. In addition, they made the Federal Reserve banks quasi-private institutions overseen by directors from the private sector living in that district who represent views from that region and are in close contact with the president of the Federal Reserve bank. The unusual structure of the Federal Reserve System has promoted a concern in the Fed with regional issues as is evident in Federal Reserve bank publications. Without this unusual structure, the Federal Reserve System might have been far less popular with the public, making the institution far less effective. Bank of the United States expired in 1836 after its renewal was vetoed in 1832 by President Andrew Jackson. The termination of the Second Bank’s national charter in 1836 created a severe problem for American financial markets, because there was no lender of last resort who could provide reserves to the banking system to avert a bank panic. Hence in the nineteenth and early twentieth centuries, nationwide bank panics became a regular event, occurring every twenty years or so, culminating in the panic of 1907. The 1907 panic resulted in such widespread bank failures and such substantial losses to depositors that the public was finally convinced that a central bank was needed to prevent future panics. The hostility of the American public to banks and centralized authority created great opposition to the establishment of a single central bank like the Bank of England. Fear was rampant that the moneyed interests on Wall Street (including the largest corporations and banks) would be able to manipulate such an institution to gain control over the economy and that federal operation of the central bank might result in too much government intervention in the affairs of private banks. Serious disagreements existed over whether the central bank should be a private bank or a government institution. Because of the heated debates on these issues, a compromise was struck. In the great American tradition, Congress wrote an elaborate system of checks and balances into the Federal Reserve Act of 1913, which created the Federal Reserve System with its 12 regional Federal Reserve banks (see Box 1). Formal Structure of the Federal Reserve System The formal structure of the Federal Reserve System was intended by writers of the Federal Reserve Act to diffuse power along regional lines, between the private sector and the government, and among bankers, businesspeople, and the public. This initial diffusion of power has resulted in the evolution of the Federal Reserve System to CHAPTER 14 Structure of Central Banks and the Federal Reserve System 337 www.federalreserve.gov/pubs /frseries/frseri.htm Information on the structure of the Federal Reserve System. include the following entities: the Federal Reserve banks, the Board of Governors of the Federal Reserve System, the Federal Open Market Committee (FOMC), the Federal Advisory Council, and around 4,800 member commercial banks. Figure 1 outlines the relationships of these entities to one another and to the three policy tools of the Fed (open market operations, the discount rate, and reserve requirements) discussed in Chapters 15 to 17. Federal Reserve Banks Each of the 12 Federal Reserve districts has one main Federal Reserve bank, which may have branches in other cities in the district. The locations of these districts, the Federal Reserve banks, and their branches are shown in Figure 2. The three largest Federal Reserve System Appoints three directors to each FRB Board of Governors Twelve Federal Reserve Banks (FRBs) Seven members appointed by the president of the United States and confirmed by the Senate Each with nine directors who appoint president and other officers of the FRB Elect six directors to each FRB Select Federal Open Market Committee (FOMC) Federal Advisory Council Twelve members (bankers) Seven members of Board of Governors plus presidents of FRB of New York and four other FRBs Establish Reviews and determines Directs Sets (within limits) Policy Tools Around 4,800 member commercial banks Reserve requirements Open market operations F I G U R E 1 Formal Structure and Allocation of Policy Tools in the Federal Reserve Discount rate 338 PART IV Central Banking and the Conduct of Monetary Policy Seattle 1 Helena Portland 9 2 Minneapolis Detroit 7 12 4 Pittsburgh Chicago San Francisco Omaha Salt Lake City Cleveland 10 Denver Cincinnati Kansas City Culpeper St. Louis Louisville 8 Los Angeles Charlotte Memphis Oklahoma City Little Rock Boston Buffalo 3 New York Philadelphia Baltimore WASHINGTON Richmond 5 Nashville Birmingham Birming Atlanta Dallas 1 Federal Reserve districts Board of Governors of the Federal Reserve System Federal Reserve bank cities El Paso Federal Reserve branch cities Boundaries of Federal Reserve districts (Alaska and Hawaii are in District 12) 6 11 Jacksonville Houston New Orleans San Antonio Miami F I G U R E 2 Federal Reserve System Source: Federal Reserve Bulletin. www.federalreserve.gov /otherfrb.htm Addresses and phone numbers of Federal Reserve banks, branches, and RCPCs and links to the main pages of the 12 reserve banks and Board of Governors. Federal Reserve banks in terms of assets are those of New York, Chicago, and San Francisco—combined they hold over 50% of the assets (discount loans, securities, and other holdings) of the Federal Reserve System. The New York bank, with around onequarter of the assets, is the most important of the Federal Reserve banks (see Box 2). Each of the Federal Reserve banks is a quasi-public (part private, part government) institution owned by the private commercial banks in the district that are members of the Federal Reserve System. These member banks have purchased stock in their district Federal Reserve bank (a requirement of membership), and the dividends paid by that stock are limited by law to 6% annually. The member banks elect six directors for each district bank; three more are appointed by the Board of Governors. Together, these nine directors appoint the president of the bank (subject to the approval of the Board of Governors). The directors of a district bank are classified into three categories, A, B, and C: The three A directors (elected by the member banks) are professional bankers, and the three B directors (also elected by the member banks) are prominent leaders from industry, labor, agriculture, or the consumer sector. The three C directors, who are appointed by the Board of Governors to represent the public interest, are not allowed to be officers, employees, or stockholders of banks. This design for choosing directors was intended by the framers of the Federal Reserve Act to ensure that the directors of each Federal Reserve bank would reflect all constituencies of the American public. CHAPTER 14 Structure of Central Banks and the Federal Reserve System 339 Box 2: Inside the Fed The Special Role of the Federal Reserve Bank of New York The Federal Reserve Bank of New York plays a special role in the Federal Reserve System for several reasons. First, its district contains many of the largest commercial banks in the United States, the safety and soundness of which are paramount to the health of the U.S. financial system. The Federal Reserve Bank of New York conducts examinations of bank holding companies and state-chartered banks in its district, making it the supervisor of some of the most important financial institutions in our financial system. Not surprisingly, given this responsibility, the bank supervision group is one of the largest units of the New York Fed and is by far the largest bank supervision group in the Federal Reserve System. The second reason for the New York Fed’s special role is its active involvement in the bond and foreign exchange markets. The New York Fed houses the open market desk, which conducts open market operations—the purchase and sale of bonds—that determine the amount of reserves in the banking system. Because of this involvement in the Treasury securities market, as well as its walking-distance location near the New York and American Stock Exchanges, the officials at the Federal Reserve Bank of New York are in constant contact with the major domestic financial markets in the United States. In addition, the Federal Reserve Bank of New York also houses the foreign exchange desk, which conducts foreign exchange interventions on behalf of the Federal Reserve System and the U.S. Treasury. Its involvement in these financial markets means that the New York Fed is an important source of information on what is happening in domestic and foreign financial markets, particularly during crisis periods, as well as a liaison between officials in the Federal Reserve System and private participants in the markets. The third reason for the Federal Reserve Bank of New York’s prominence is that it is the only Federal Reserve bank to be a member of the Bank for International Settlements (BIS). Thus the president of the New York Fed, along with the chairman of the Board of Governors, represents the Federal Reserve System in its regular monthly meetings with other major central bankers at the BIS. This close contact with foreign central bankers and interaction with foreign exchange markets means that the New York Fed has a special role in international relations, both with other central bankers and with private market participants. Adding to its prominence in international circles is that the New York Fed is the repository for over $100 billion of the world’s gold, an amount greater than the gold at Fort Knox. Finally, the president of the Federal Reserve Bank of New York is the only permanent member of the FOMC among the Federal Reserve bank presidents, serving as the vice-chairman of the committee. Thus he and the chairman and vice-chairman of the Board of Governors are the three most important officials in the Federal Reserve System. The 12 Federal Reserve banks perform the following functions: • • • • • • • • • 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 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 their staffs of professional economists to research topics related to the conduct of monetary policy 340 PART IV Central Banking and the Conduct of Monetary Policy The 12 Federal Reserve banks are involved in monetary policy in several ways: 1. Their directors “establish” the discount rate (although the discount rate in each district is reviewed and determined by the Board of Governors). 2. They decide which banks, member and nonmember alike, can obtain discount loans from the Federal Reserve bank. 3. Their directors select one commercial banker from each bank’s district to serve on the Federal Advisory Council, which consults with the Board of Governors and provides information that helps in the conduct of monetary policy. 4. Five of the 12 bank presidents each have a vote in the Federal Open Market Committee, which directs open market operations (the purchase and sale of government securities that affect both interest rates and the amount of reserves in the banking system). As explained in Box 2, the president of the New York Fed always has a vote in the FOMC, making it the most important of the banks; the other four votes allocated to the district banks rotate annually among the remaining 11 presidents. Member Banks All national banks (commercial banks chartered by the Office of the Comptroller of the Currency) are required to be members of the Federal Reserve System. Commercial banks chartered by the states are not required to be members, but they can choose to join. Currently, around one-third of the commercial banks in the United States are members of the Federal Reserve System, having declined from a peak figure of 49% in 1947. Before 1980, only member banks were required to keep reserves as deposits at the Federal Reserve banks. Nonmember banks were subject to reserve requirements determined by their states, which typically allowed them to hold much of their reserves in interest-bearing securities. Because no interest is paid on reserves deposited at the Federal Reserve banks, it was costly to be a member of the system, and as interest rates rose, the relative cost of membership rose, and more and more banks left the system. This decline in Fed membership was a major concern of the Board of Governors (one reason was that it lessened the Fed’s control over the money supply, making it more difficult for the Fed to conduct monetary policy). The chairman of the Board of Governors repeatedly called for new legislation requiring all commercial banks to be members of the Federal Reserve System. One result of the Fed’s pressure on Congress was a provision in the Depository Institutions Deregulation and Monetary Control Act of 1980: All depository institutions became subject (by 1987) to the same requirements to keep deposits at the Fed, so member and nonmember banks would be on an equal footing in terms of reserve requirements. In addition, all depository institutions were given access to the Federal Reserve facilities, such as the discount window (discussed in Chapter 17) and Fed check clearing, on an equal basis. These provisions ended the decline in Fed membership and reduced the distinction between member and nonmember banks. Board of Governors of the Federal Reserve System At the head of the Federal Reserve System is the seven-member Board of Governors, headquartered in Washington, D.C. Each governor is appointed by the president of the United States and confirmed by the Senate. To limit the president’s control over the Fed and insulate the Fed from other political pressures, the governors serve one CHAPTER 14 www.federalreserve.gov/bios /1199member.pdf Lists all the members of the Board of Governors of the Federal Reserve since its inception. Federal Open Market Committee (FOMC) Structure of Central Banks and the Federal Reserve System 341 nonrenewable 14-year term, with one governor’s term expiring every other January.1 The governors (many are professional economists) are required to come from different Federal Reserve districts to prevent the interests of one region of the country from being overrepresented. The chairman of the Board of Governors is chosen from among the seven governors and serves a four-year term. It is expected that once a new chairman is chosen, the old chairman resigns from the Board of Governors, even if there are many years left to his or her term as a governor. The Board of Governors is actively involved in decisions concerning the conduct of monetary policy. All seven governors are members of the FOMC and vote on the conduct of open market operations. Because there are only 12 voting members on this committee (seven governors and five presidents of the district banks), the Board has the majority of the votes. The Board also sets reserve requirements (within limits imposed by legislation) and effectively controls the discount rate by the “review and determination” process, whereby it approves or disapproves the discount rate “established” by the Federal Reserve banks. The chairman of the Board advises the president of the United States on economic policy, testifies in Congress, and speaks for the Federal Reserve System to the media. The chairman and other governors may also represent the United States in negotiations with foreign governments on economic matters. The Board has a staff of professional economists (larger than those of individual Federal Reserve banks), which provides economic analysis that the board uses in making its decisions. (Box 3 discusses the role of the research staff.) Through legislation, the Board of Governors has often been given duties not directly related to the conduct of monetary policy. In the past, for example, the Board set the maximum interest rates payable on certain types of deposits under Regulation Q. (After 1986, ceilings on time deposits were eliminated, but there is still a restriction on paying any interest on business demand deposits.) Under the Credit Control Act of 1969 (which expired in 1982), the Board had the ability to regulate and control credit once the president of the United States approved. The Board of Governors also sets margin requirements, the fraction of the purchase price of securities that has to be paid for with cash rather than borrowed funds. It also sets the salary of the president and all officers of each Federal Reserve bank and reviews each bank’s budget. Finally, the Board has substantial bank regulatory functions: It approves bank mergers and applications for new activities, specifies the permissible activities of bank holding companies, and supervises the activities of foreign banks in the United States. The FOMC usually meets eight times a year (about every six weeks) and makes decisions regarding the conduct of open market operations, which influence the monetary base. Indeed, the FOMC is often referred to as the “Fed” in the press: for example, when the media say that the Fed is meeting, they actually mean that the FOMC is meeting. The committee consists of the 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. The chairman of the Board of Governors also presides as the chairman of the FOMC. Even though only the presidents of five of the Federal Reserve 1 Although technically the governor’s term is nonrenewable, a governor can resign just before the term expires and then be reappointed by the president. This explains how one governor, William McChesney Martin Jr., served for 28 years. Since Martin, the chairman from 1951 to 1970, retired from the board in 1970, the practice of extending a governor’s term beyond 14 years has become a rarity. 342 PART IV Central Banking and the Conduct of Monetary Policy Box 3: Inside the Fed The Role of the Research Staff The Federal Reserve System is the largest employer of economists not just in the United States, but in the world. The system’s research staff has around 1,000 people, about half of whom are economists. Of these 500 economists, 250 are at the Board of Governors, 100 are at the Federal Reserve Bank of New York, and the remainder are at the other Federal Reserve banks. What do all these economists do? The most important task of the Fed’s economists is to follow the incoming data from government agencies and private sector organizations on the economy and provide guidance to the policymakers on where the economy may be heading and what the impact of monetary policy actions on the economy might be. Before each FOMC meeting, the research staff at each Federal Reserve bank briefs its president and the senior management of the bank on its forecast for the U.S. economy and the issues that are likely to be discussed at the meeting. The research staff also provides briefing materials or a formal briefing on the economic outlook for the bank’s region, something that each president discusses at the FOMC meeting. Meanwhile, at the Board of Governors, economists maintain a large econometric model (a model whose equations are estimated with statistical procedures) that helps them produce their forecasts of the national economy, and they too brief the governors on the national economic outlook. The research staffers at the banks and the board also provide support for the bank supervisory staff, tracking developments in the banking sector and other financial markets and institutions and providing bank examiners with technical advice that they might need in the course of their examinations. Because the Board of Governors has to decide on www.federalreserve.gov/fomc Find general information on the FOMC, its schedule of meetings, statements, minutes, and transcripts; information on its members, and the “beige book.” whether to approve bank mergers, the research staff at both the board and the bank in whose district the merger is to take place prepare information on what effect the proposed merger might have on the competitive environment. To assure compliance with the Community Reinvestment Act, economists also analyze a bank’s performance in its lending activities in different communities. Because of the increased influence of developments in foreign countries on the U.S. economy, the members of the research staff, particularly at the New York Fed and the Board, produce reports on the major foreign economies. They also conduct research on developments in the foreign exchange market because of its growing importance in the monetary policy process and to support the activities of the foreign exchange desk. Economists also help support the operation of the open market desk by projecting reserve growth and the growth of the monetary aggregates. Staff economists also engage in basic research on the effects of monetary policy on output and inflation, developments in the labor markets, international trade, international capital markets, banking and other financial institutions, financial markets, and the regional economy, among other topics. This research is published widely in academic journals and in Reserve bank publications. (Federal Reserve bank reviews are a good source of supplemental material for money and banking students.) Another important activity of the research staff primarily at the Reserve banks is in the public education area. Staff economists are called on frequently to make presentations to the board of directors at their banks or to make speeches to the public in their district. banks are voting members of the FOMC, the other seven presidents of the district banks attend FOMC meetings and participate in discussions. Hence they have some input into the committee’s decisions. Because open market operations are the most important policy tool that the Fed has for controlling the money supply, the FOMC is necessarily the focal point for policymaking in the Federal Reserve System. Although reserve requirements and the discount rate are not actually set by the FOMC, decisions in regard to these policy tools