Things to Have Websites/Slides s1

Lecture Notes – October 12th

Things to have – websites/slides

articles

http://www.minneapolisfed.org/community_education/student/centralbankhistory/bank.cfm

http://www.fdic.gov/75exhibit/FDIC1/highlight.html

http://www.federalreserve.gov/pf/pf.htm

http://www.philadelphiafed.org/publications/speeches/plosser/2010/02-17-10_world-affairs-council.cfm

Bank of England

Today we are going to talk about the Bank of England and the European Central Banks. We will look at relative similarities between these institutions and also some key differences.

The Bank of England founding in 1694 is one of the oldest central banks in the world. It was given a royal charter with an initial loan of 1.2m GBP to the crown – thus it was privately owned until 1946 when it was nationalized. It managed the government’s accounts and finances and was a commercial bank making loans and taking deposits.

Prior to 1997 it was one of the least independent central banks. Short term interest rates were set by the government through the chancellor of the exchequer. In May 1997 the Labour party came into power. Their inflation fighting credentials were much worse than the conservative party’s. The fear was that in order to keep control of inflation the labour government would have to keep interest rates at a higher level than a conservative government would have had to. Not only is inflation a key driver of monetary policy but so are expectation of inflation.

Thus Gordon Brown, the then Chancellor of the Exchequer, announced that the Bank of England would be given the power to set interest rates. Thus he took the UK down the path of central bank independence and solved a serious political problem at the same time

The Bank of England has two core purposes (its own terminology)

· Core Purpose 1 - Monetary Stability

o Monetary stability means stable prices and confidence in the currency. Stable prices are defined by the Government's inflation target, which the Bank seeks to meet through the decisions delegated to the Monetary Policy Committee, explaining those decisions transparently and implementing them effectively in the money markets.

· Core Purpose 2 - Financial Stability

o Financial stability entails detecting and reducing threats to the financial system as a whole. This is pursued through the Bank's financial and other operations, including lender of last resort, oversight of key infrastructure and the surveillance and policy roles delegated to the Financial Policy Committee.

The equivalent of the FOMC in the Bank of England is the Monetary Policy Committee. It is chaired by the Governor of the Bank of England and includes 5 full time bank of England employees and 4 external members who are appointed by the Chancellor of the Exchequer for terms of three years each. The Governor is a civil service post but generally is appointed from within the bank and he holds the position for 1 five year term – renewable once.

European Central Bank

We probably should start with a bit of background.

1952 - The European Union started out as the European Coal and Steel Community founded by Germany, France, Belgium, Italy, Luxembourg and the Netherlands. The idea was to remove the resources coal and steel from national sovereignty in order to preserve lasting peace.

1979 – European Monetary System – The key feature here was the exchange rate mechanism (ERM) which introduced fixed by flexible exchange rates among the countries of the EEC (At this point included Denmark, Ireland and the UK).

There were three stages towards creating the monetary union we have today.

1990 – the abolition of barriers to the movement of goods and people between countries in the EU

1993 – Maastricht Treaty set out the conditions that had to be satisfied to enter into the monetary union.

1994 – The creation of the European Monetary Institute – the predecessor of the ECB. The focus was on laying the groundwork for monetary union, enforcing budgetary discipline. Etc

1998 – the founding of the ECB

1999 – started with the irrevocable fixing of the conversion rates of the exchange rates of the 11 member states originally participating.

2002 – the introduction of coins and banknotes in Euros

Now for the mess that is Europe.

First let’s start with the ESCB – European System of Central Banks

This comprises the ECB and also the 27 national central banks of all member states including those that have not joined the EURO. The countries that have not joined the EURO still have their own national currency, for which they conduct their own monetary policy. They are committed though to the principles of monetary policy and in particular those aimed at price stability.

Then one has the Eurosystem - these describes the ECB and the 17 national central banks that use the EURO. Since the monetary policy decisions of the ECB only really affect these 17 countries directly this is the group that carries out monetary policy for the region.

This is similar to the situation with the Federal Reserve. A decision was taken to keep the existing central banks within the Eurosystem and not have a monolithic central bank.

Some advantages of this structure is that:

· Some of the national central banks have other functions as well so structurally it makes sense to keep them.

· Given the large and diverse geographical area within the Euro system it makes sense to give local institutions a local and familiar access into the central banking system.

· The ECB is owned by the national central banks within the ESCB.

The ECB has two main bodies – similar to the Fed. There is the executive board and the governing council. The executive board is made up of the president, vice president and four other members who are appointed to 8-year non-renewable terms. They are appointed by a committee consisting of the heads of states of all countries in the Eurosystem. The Governing council is made up of the Executive Board and the presidents of the NCBs from all countries in the Eurosystem.

This is a much more unwieldy institution than the FOMC. There are 17 countries in the Eurozone so this board consists of 23 people.

The goal of the ESCB is very clear. The primary objective of the ESCB is to maintain price stability.

This has been refined by the Governing Council to mean:

Price Stability shall be defined as a year-on-year increase in the Harmonized Index of Consumer Prices for the euro area of below 2%. Price Stability is to be maintained over the medium term. The governing council aims to maintain inflation rates at levels below, but close to 2%

Independence of the ECB.

The ECB is one of the most independent of all central banks. It has been given a mandate on Price Stability within one of the European treaties. The governing council has the power to decide how to interpret the mandate.

The ECB describes itself as having 4 kinds of independence.

Functional independence. This is the same as instrument independence. It is all about having the tools to carry out monetary policy and being free to use them as seen fit.
Institutional Independence. This is a strict prohibition on allowing governments to try to influence monetary policy.
Personal independence – The ECB is designed to make sure that individuals on the governing council of the ECB have sufficient tenure to be able to not be subject to political pressure. They have minimum terms of 5 years.
Financial Independence – the goal here is to make sure that the central bank has sufficient financial resources to fulfill their mandate. In addition not to have its resources subject to political pressure.

Note the ECB has another type of independence that the Fed does not. In order to change the structure or mandate of the ECB one must change the Maastricht treaty. This involves all signatories to the treaty agreeing to any proposed change. This is very difficult to achieve.

The ECB is similar to the Federal Reserve in that it is given a mandate to maintain price stability but is free to interpret this accordingly.

Functional independence

Functional independence requires a primary objective determined by clarity and legal certainty that provides the central bank with the necessary means and instruments to achieve this objective, independently of any other authority. The primary objective of the ESCB, as set down in the Treaty on the Functioning of the European Union and the ESCB Statute, is the maintenance of price stability.

Institutional independence

The principle of institutional independence is expressly referred to in Articles 130 and 282 of the Treaty on the Functioning of the European Union and Article 7 of the ESCB Statute. These provisions prohibit the ECB, the NCBs and members of their decision-making bodies from seeking or taking instructions from Union institutions or bodies, from any government of a Member State or from any other body. In addition, they also prohibit such institutions, governments and bodies from seeking to influence the members of the decision-making bodies of the ECB or the NCBs.

Personal independence

The Statute's provisions on security of tenure for members of the ECB's decision-making bodies further safeguard central bank independence. Such provisions stipulate a minimum term of office of five years for NCB governors (renewable), and a non-renewable term of office of eight years for the members of the ECB's Executive Board. Furthermore, members of the decision-making bodies may not be dismissed for reasons other than those stipulated in the ESCB Statute.

Financial independence

The ECB and the NCBs must have autonomous access to sufficient financial resources to fulfil their mandates. The ECB has its own capital, subscribed and paid up by the NCBs. It also has its own budget independent from that of the other European institutions. As regards the NCBs, Member States may not put their NCBs in the position of not having sufficient financing resources to carry out their ESCB-related and own national tasks.

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The ECB has several tools at its disposal to carry out monetary policy. These include:

Standing Facilities –

▪ the marginal lending facility, which allows counterparties (i.e. financial institutions such as banks) to obtain overnight liquidity from the national central banks against eligible assets; and

▪ the deposit facility, which can be used by counterparties to make overnight deposits with the national central banks.

Open Market Operations

· the main refinancing operations, which are regular liquidity-providing reverse transactions with a weekly frequency and a maturity of one week;

· the longer-term refinancing operations, which are liquidity-providing reverse transactions with a monthly frequency and a maturity of, normally, three months;

· fine-tuning operations, executed on an ad hoc basis and aimed at managing the liquidity situation in the money market and at steering interest rates, in particular in order to smooth the effects on interest rates caused by unexpected market liquidity fluctuations;

· structural operations, executed whenever the ECB wishes to adjust the structural liquidity position of the Eurosystem vis-à-vis the financial sector (on a regular or non-regular basis), for example, the amount of liquidity in the market over the longer term. These operations can be conducted using reverse transactions, outright operations or the issuance of ECB debt certificates.

Minimum Reserves

Finally, the Eurosystem requires credit institutions to hold minimum reserves on accounts with the national central banks. The purpose of the minimum reserve system is to stabilise money market interest rates and create (or enlarge) a structural liquidity shortage.