Chapter 16 The Structure of Central Banks: The Federal Reserve and the European Central Bank Conceptual and Analytical Problems What are the Federal Reserve’s goals and who established them? How are Fed officials held accountable for meeting them? Explain why the Chair is most influential Fed official. Answer: Congress mandates the Federal Reserve to “maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." The Fed releases large amounts of information in order to maintain accountability. After each FOMC meeting, the target interest rate is announced immediately, along with a brief statement. Minutes are available after three weeks and transcripts after five years. Members of the FOMC give public speeches and the chair reports to Congress twice a year. The 2012 introduction of a numerical inflation objective (based on the price index of personal consumption expenditures) allows the public to assess the Fed’s performance in meeting its congressionally-mandated goals. Finally, as leader of the FOMC, the Fed Chair influences policy by controlling (i) the staff of the Board of Governors that produces the material distributed to FOMC members prior to meetings, (ii) the agenda of FOMC meetings, (iii) the order in which people speak, and (iv) the policy alternatives from which the Committee chooses. Go to the Federal Reserve Board's website and locate the FOMC’s most recent statement. What did the committee members say at their last meeting regarding the target range for the Federal funds range and the two goals of price stability and sustainable economic growth? Answer: In a statement released February 1, 2017, the FOMC stated: "In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1/2 to 3/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a return to 2 percent inflation." Some people have argued that the high inflation of the late 1970s was a consequence of the fact that Federal Reserve Board Chairman Arthur Burns did what President Richard Nixon wanted him to do. What policy do you think Nixon might have wanted?
Answer: Because politicians are elected for relatively short terms, they often favor expansionary monetary policy that will boost economic growth in the short run. However, such an expansionary policy will eventually lead to higher inflation. Independence allows the central bank to focus on its long-run goals instead of short-term political objectives. How might the ECB’s pursuit of price stability as its primary objective restrict its response to the sovereign debt crisis in the euro area? Answer: A short-term solution to the sovereign debt crisis would be for the ECB to buy all the bonds of the highly indebted countries that they are unable to sell to private investors (until the governments can repair their national balance sheets). However, an unlimited purchase of bonds would increase the money supply in the euro area and could lead to higher inflation and a loss of ECB credibility. Evaluate the following statement: “The Treaty of Maastricht helped solve the time consistency problem in monetary policy but not fiscal policy.” Answer: The time consistency problem for monetary policy was addressed by establishing a highly independent central bank. Independence resulted from features such as long terms (without reappointment) for Executive Board members, irreversible policy decisions, and the need for a treaty modification to alter the ECB structure or its price stability mandate. However, the Treaty lacked credible ways to ensure good fiscal performance in each country. In some countries, fiscal policy operated with limited regard for the long-run implications of rising debts. Perhaps more important, fiscal well-being was undermined by unforeseen risks, such as the need in several countries to recapitalize their banking systems. How did the response to the financial crisis of 2007-2009 alter the appointment process of presidents of the regional Federal Reserve banks? Answer: The bailouts of financial institutions during the crisis fueled a public perception that the regional reserve banks are too sympathetic to the private banks, in part because presidents of regional Feds often are selected from the ranks of private bankers. As part of the Dodd-Frank Act, Congress decided that the three bank representatives on the nine-member boards of each Federal Reserve Bank would no longer have a vote in selecting the bank president. This change was modest compared to earlier proposals, one of which would have made the bank presidents direct appointees of the U.S. President (subject to approval by the U.S. Senate), similar to the members of the Federal Reserve Board. What are the goals of the ECB? How are its officials held accountable for meeting them? Answer: The primary goal of the ECB is to maintain price stability, which the ECB defines as an annual inflation rate of less than, but close to, two percent using the Harmonized Index of Consumer Prices. Like the Federal Reserve, the ECB is held accountable through releases of information, including its target interest rate, the explanatory statements that follow its meetings, regular reports to the European Parliament, frequent publications, and public speeches. Why did the sovereign debt problem of Greece – which accounts for less than 2 percent of euro-area GDP – threaten the banking system throughout the euro area? Answer: Banks throughout the euro area held Greek government debt. When its value fell, bank capital at these banks declined, making banks throughout the region riskier than before. More important, concerns about sovereign default and about a possible exit of Greece from the euro area proved contagious, leading the prices of sovereign debt in several euro-area economies (especially, Ireland, Italy, Portugal, and Spain) to plummet. Sharp declines in these bond prices aggravated the hit to capital in the euro-area banking system. Partly as a result, banks became more cautious about lending to each other (a version of the “lemons” problem). Finally, the spreading sovereign debt and banking crisis was associated with a prolonged and deep economic recession that damaged other assets on the banks’ balance sheets (including, for example, real estate-related loans). In some countries – such as Greece and Spain – the recessions resulted in Great Depression-level unemployment. Go to the ECB's web site and locate the most recent introductory statement made by the president of the ECB at the press conference following a Governing Council meeting. What was the Governing Council’s policy decision? How was it justified? Is there any reference to financial stability measures? Answer: In the introductory statement at the press conference following the Governing Council's meeting, Mario Draghi, President of the ECB stated, "we decided to keep the key ECB interest rates unchanged. We continue to expect them to remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases." Draghi justified this stance by stating that, "Borrowing conditions for firms and households continue to benefit from the pass-through of our measures. As expected, headline inflation has increased lately, largely owing to base effects in energy prices, but underlying inflation pressures remain subdued." Draghi only noted "if the outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, we stand ready to increase our asset purchase programme in terms of size and/or duration," regarding financial stability. Do you think the FOMC has an easier or a harder time agreeing on monetary policy than the Governing Council of the ECB? Why? Answer: The FOMC and ECB have similar numerical inflation objectives. However, the presence of national biases may make agreement among members of the Governing Council of the ECB more difficult. By contrast, the Federal Reserve has very little regional bias. Also, a group of 12 (the number of voting FOMC members) is likely to have an easier time coming to a decision than a group of 25 (the current number of ECB Governing Council members). Why did the “no-bailout” clause of the Maastricht Treaty come under stress during the financial crisis of 2007-2009? Answer: Large fiscal deficits in some euro-area countries threatened the ability of those governments to borrow. A disruption to sovereign borrowing in one country would not only cause economic and banking difficulties in that country, but would likely threaten the economies and banking systems of other euro area members due to their strong inter-linkages. Do you think the current procedures for appointing members to the Board of Governors are consistent with the principles of good central bank design? Explain your answer. Answer: The length of the terms and the fact they are staggered reduces the opportunity for political influence on the selection of the governors and so these procedures are consistent with central bank independence. However, the governors are still appointed by the president and confirmed by the Senate. These practices can be interpreted as a pragmatic way of institutionalizing central bank independence in a democratic society. Currently, all the national central banks in the Eurosystem are involved with the day-to-day implementation of monetary policy. What do you think the advantage would be of centralizing the conduct of these day-to-day interactions with financial markets at the ECB in Frankfurt? Are there any disadvantages you can think of? Answer: The main advantage would be in terms of efficiency. Conducting these interactions at 19 different national central banks is more cumbersome than having one central point of contact with financial markets. Having one center would also promote the treatment of the Eurosystem as a single integrated market as opposed to a collection of separate national market segments. A possible disadvantage would be the loss of local market knowledge, although this issue should become less and less important over time. If you were charged with re-drawing the boundaries of the Federal Reserve districts, what criteria would you use to complete the task? Answer: Ideally, the districts should reflect a diverse range of economic interests. Other factors to consider might include the levels of population, of economic activity, and of financial activity. Entering 2016, interest rates and inflation had been low for some time. The FOMC added to its annual statement of longer-run goals that it would be “concerned if inflation were running persistently above or below” its inflation-rate objective of 2 percent over the longer term. Why might the FOMC have emphasized this “symmetry” of its price-stability goal? Answer: The symmetry of the inflation objective encourages expectations that— whether inflation is persistently above or persistently below the 2% goal—the FOMC will act over time to restore inflation to the goal. In the 1980s and 1990s, the FOMC had acted to lower inflation after it had risen well above 2%. In 2016, the FOMC’s challenge was to raise inflation to its objective and to limit fears of deflation. In this context, the symmetry of the Fed’s inflation objective helps to stabilize long-run inflation expectations. Because long-run inflation expectations influence firms’ price- and wage-setting, FOMC transparency also helps to stabilize inflation. The FOMC made the statement when both interest rates and inflation had been persistently low and long-term inflation expectations were edging lower, so emphasizing the “symmetry” of the price-stability objective was consistent with boosting long-term inflation expectations. Why do you think the statement released after each Federal Open Market Committee meeting retains the same basic structure? Answer: Maintaining the same structure for the statement promotes transparency and is thought to be a good communication strategy. The market knows what information it will be getting. If the structure of the statement constantly changed, the markets might misinterpret these changes as signals about the stance of policy that the committee did not intend to give. Do you think, in the interest of transparency, the Chair of the Federal Reserve Board should explain in detail the subtleties surrounding policy decisions? Why or why not? Answer: Since 2012, the Fed Chair has conducted quarterly press conferences following those FOMC meetings where members’ quantitative economic and policy rate forecasts are published. This practice mirrors the communications strategy of the ECB, which conducts a press conference (led by its President and Vice President) following each Governing Council meeting. However, there can be tradeoffs between transparency and effective communication strategy. Being more open about how policy decisions are arrived at enhances transparency, but it can lead to confusion and uncertainty when the decisions themselves are unclear or contentious. Suppose a fellow student in your money and banking class made the following statement: “Given that the Federal Reserve now specifies a numerical target for inflation but not for maximum employment, it has, in effect, a hierarchical mandate like the ECB, placing primacy on the price stability part of its mandate.” On what basis could you disagree with this student? Answer: Expressing a numerical target for inflation but not for the maximum employment element of the mandate does not imply that greater importance is placed on the former. As the monetary authority, the Fed exerts controls inflation over the long run, but it does not control output and employment over the long run. The absence of a numerical target for the latter reflects this reality. Moreover, the Fed has stated that if the goals of its dual mandate come into conflict, it will take a “balanced approach”, emphasizing the equal standing of both parts of the mandate. Compare the communication strategies of the Federal Reserve and the ECB. In what ways are they similar? Identify two key elements of the Fed’s strategy that are not part of the ECB’s strategy and discuss whether you think the ECB is justified in omitting each of them. Answer: The communication strategies of the Fed and the ECB share many common elements: they both immediately release the target interest rate with a statement after policy meetings and hold periodic press conferences. They both release an account of their policy meetings with a short lag, report periodically to a democratically elected body, give public speeches and disseminate data and research. In contrast to the ECB, the Fed makes public the votes of individual votes of the members of its policy-making committee while the ECB does not. The Fed also publishes transcripts of its meetings after a five-year lag. Not publishing votes of Governing Council members can be justified on the basis that it makes it more feasible for members who represent individual countries to base their vote on the needs of the economy of the euro area as a whole (as they are charged to do) rather than on the basis of a narrower, national perspective. This rationale could be stretched to also justify the absence of published transcripts, but this argument is significantly weaker because a transcript could be published with a long lag. During the euro-area crisis, interest-rate spreads between the sovereign debt of peripheral countries and Germany widened most sharply when it was feared that one or more countries might leave the euro area. These spreads narrowed when ECB actions restored confidence in the monetary union. What accounts for this pattern? Data Exploration How large are the public debt burdens of key euro-area economies? Are they rising or falling? Plot the debt-to-GDP ratios of Germany (FRED code: GGGDTADEA188N), Italy (FRED code: GGGDTAITA188N) and the euro area as a whole (FRED code: GGGDTAEZA188N). Extend each line using the projections of the International Monetary Fund (FRED codes: GGGDTPDEA188N and GGGDTPITA188N, respectively). Are these ratios consistent with the Maastricht Treaty’s public debt-to-GDP guideline of 60 percent? ( Answer: As of 2015, even Germany, the largest and perhaps the healthiest of the big euro-area economies, has a debt-to-GDP ratio above the 60% guideline for the euro area. Italy’s ratio is more than twice the suggested level. Moreover, these public debt-to-GDP ratios rose substantially after 2007. While Germany’s ratio began to decline after 2010, Italy’s continued to rise. Going forward, the IMF projects some improvement for Italy, but from an elevated level. International Monetary Fund, General government gross debt for Germany© [GGGDTADEA188N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GGGDTADEA188N. International Monetary Fund, Projection of General government gross debt for Germany© [GGGDTPDEA188N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GGGDTPDEA188N. International Monetary Fund, General government gross debt for Italy© [GGGDTAITA188N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GGGDTAITA188N, International Monetary Fund, Projection of General government gross debt for Italy© [GGGDTPITA188N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GGGDTPITA188N. The European Central Bank (ECB) has translated its primary objective of price stability into an explicit, quantitative goal of keeping euro-area annual inflation close to, but below, 2 percent over the medium term. Plot the percent change from a year ago of the euro-area price level called the “harmonized index of consumer prices” (FRED code: CP0000EZ19M086NEST). Evaluate the performance of the ECB on average since 2000 and over shorter intervals. Download the data and compute the average inflation rate for the full period and for the periods 2008-2009, 2010-2011, and 2012-present. Answer: The plot is shown below. Over short periods, measured inflation varies significantly as a result of temporary price disturbances that do not affect the trend of inflation. Moreover, monetary policy changes influence inflation only with a lag. As a result, monetary policy cannot reasonably be expected to hold average inflation at a specified numerical value over intervals much less than two years. Over the period since 2000, euro-area inflation has averaged 1.8 percent: approximately the ECB’s goal. For 2008-2009, inflation averaged 1.8 percent; for 2010-2011, the average was 2.2 percent. However, from January 2012 to the present (through July, 2016), the average was only 0.9 percent. As of mid-2016, the ECB is pursuing expansionary policies to raise the euro-area inflation rate toward its goal of just below 2 percent. Eurostat, Harmonized Index of Consumer Prices: All Items for Euro area (19 countries)© [CP0000EZ19M086NEST], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CP0000EZ19M086NEST. In 2012, the Federal Reserve announced an inflation objective of 2 percent “over the longer run” for the personal consumption expenditures price index (FRED code: PCEPI). However, many analysts focus on the “core” price index (FRED code: PCEPILFE), which omits the volatile food and energy components. For the Fed’s horizon, does this difference matter? Plot the percent change from a year ago for both inflation measures since 2000. Download the data and compute the averages and standard deviations over that period. What do you conclude? Answer: The core index is relatively useful for examining the trend of inflation, because volatile components of the headline price index can mask its underlying trend. Over long periods of time, however, such temporary disturbances fade, so these measures should be more alike, unless food and energy prices deviate from other prices on a trend basis. From January 2000 to June 2016, headline inflation averaged 1.9 percent, while core inflation averaged 1.7 percent. Implicitly, food and energy prices rose somewhat faster over this period than other prices. Notably, the standard deviation of the core inflation rate was only 0.4 percent (versus 1.0 percent for the headline rate). The smaller standard deviation of the core measure means that it is usually a more reliable signal of the underlying inflation trend. Its statement of July 27, 2016, indicated that the FOMC it would pursue policies to meet its “objectives of maximum employment and 2 percent inflation.” Plot since 2009 the evolution of the FOMC’s longer-run projection for the unemployment rate (FRED code: UNRATECTMLR), the actual unemployment rate (FRED code: UNRATE), and the percent change from a year ago of the core for personal consumption expenditures price index (FRED code: PCEPILFE). Summarize the description provided by FRED (beneath the plot) of the FOMC longer-run unemployment projection. Then use the plot to explain why the FOMC statement indicated that the federal funds interest rate will likely remain for some time “below levels that are expected to prevail in the longer run.” Answer: The midpoint of the projections of members of the FOMC reflects the median estimate of the “normal” unemployment rate consistent with “maximum employment.” By mid-2016, the actual unemployment rate had reached that level. However, inflation as measured by the percent change from a year ago of the core PCE index remained persistently below the objective of 2 percent. Presumably, the FOMC expressed the intent to maintain the target federal funds rate at a relatively low level because the decline in the unemployment rate had not yet boosted inflation to the Fed’s target. Keep in mind that the FOMC has emphasized that its inflation target is symmetric, meaning that it is not biased in favor of inflation that is somewhat above 2 percent or somewhat below 2 percent. In August 2007 and in March 2008, the Federal Reserve Board reduced the discount rate to ease liquidity conditions for banks. Plot discount window borrowing (FRED code: DISCBORR) between January 2007 and December 2008. As a second line, plot on the right axis the difference between the discount rate (FRED code: DPCREDIT) and the fed funds rate target (FRED code: DFEDTAR). Did narrowing the spread between the discount rate and the federal funds target rate trigger the borrowing surge in September-October 2008? Answer: The data plot is below. The data show no immediate effect from the discount rate cut in August 2007 (that narrowed the spread to 50 basis points) and a modest initial impact from the cut in March 2008 (that narrowed the spread to 25 basis points). The September surge in discount borrowing reflected the financial panic following the failure of Lehman when interbank lending collapsed (see Chapter 3 Lessons from the Crisis: Interbank Lending), not the March change in the discount rate.
indicates more difficult problems. Solution Manual for Money, Banking and Financial Markets Stephen G. Cecchetti, Kermit L. Schoenholtz 9781259746741, 9780078021749, 9780077473075
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