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FNCE 3020
Financial Markets and Institutions
Fall Semester 2006
Lecture 6
Central Banking and the Conduct of Monetary
Policy: Impact on Financial Markets
Why Study Central Banking?
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Central bank actions have significant impacts on
financial markets:
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(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:
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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.
Definitions of a Central Bank
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The following represent published definitions of
a central bank.
Text book definition:
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“The government agency that overseas the banking
system and is responsible for the amount of money
and credit supplied in the economy.”
Other definitions:
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“The major regulatory bank in a country.”
“The government agency whose responsibilities
include:
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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.”
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.
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http://www.federalreserve.gov/sitemap.htm
Formal Structure of the Federal
Reserve System
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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
Formal Structure of the Fed
Importance of the Board of Governors
The Twelve Federal Reserve Districts
Board of Governors and the
FMOC
The seven governors are appointed by the
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President, and confirmed by the Senate, for 14-year
terms on a rotating schedule.
All are members of the Federal Open Market
Committee (FMOC):
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There are 12 members on the FOMC (7 are from
the Board of Governors)
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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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The chairman of the Board of Governors is also the
chair of the FOMC.
Policy Statements from the FOMC
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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.
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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
FOMC Press Release: August 8, 2006
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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.
Importance of the Federal Funds Rate
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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?
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Because changes in the federal funds rate trigger a chain
of events that affect:
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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.
Federal Funds Rate: 1970 - Present
Impact of Fed Funds Rate on Business
Loan Interest Rates (Prime Rate)
Impact of Fed Funds Rate on Money
Market Interest Rate (CD Rate)
Impact of Fed Funds Rate on Long
Term Corporate Bond Rate (Aaa Rate)
Impact of Fed Funds Rate on
Mortgage Lending Rate (30-Year Rate)
Impact of Federal Funds Rate on Dollar
Should Central Banks be Independent?
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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:
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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
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Central Bank may not be accountable
Hinders coordination of monetary and fiscal policy
Central Bank Independence and Inflation,
1973-1988
Central Bank Independence and Economic
Growth, 1973-1988
Major Central Banks Independence
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All of the major central banks, and many lesser central
banks, currently operate as independent central banks.
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Central Bank
Federal Reserve:
Bank of England:
Bank of Japan:
European Central Bank:
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Date of Independence*
1913
1997
1998
1999**
*Date of separation from government influence.
**ECB independence granted in original charter.
Transparency and Inflation Targeting
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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.
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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.
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Targeting refers to central banks publishing their inflation
goals and adjusting their policies to meet these goals.
Inflation Targeting Examples
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“The primary objective of the ECB’s 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 England’s monetary policy objective is to deliver
price stability…defined by the Government’s 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 Switzerland’s 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.
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
World’s Major Central Bankers
United States:
Ben Bernanke
http://www.federalreserve.gov/
European Union:
http://www.ecb.int/
Jean-Claude Trichet
Bank of England:
Mervyn King
http://www.bankofengland.co.uk/
Bank of Japan:
Toshihiko Fukui
http://www.boj.or.jp/en/index.htm
Other Useful Web Sites
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Links to all the world’s Central Banks
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Federal Reserve statistical data
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http://www.bis.org/cbanks.htm
http://www.federalreserve.gov/releases/
Economic time series, U.S. and some foreign
(also allowing for graphing of data)
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http://www.economagic.com/
Bank of England
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Founded in 1694 initially to manage the U.K.
Government’s 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 Bank’s 9 member Monetary Policy
Committee has had statutory responsibility for setting
interest rates to meet the Government's stated inflation
target.
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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.
Bank of Japan (Nippon Ginko)
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Founded in 1882.
The Bank of Japan Law (1998) gave the Bank of Japan
autonomy for monetary policy.
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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).
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Also uses an official discount rate at which it will make loans to
banks.
European Central Bank (ECB)
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Founded in January 1999 by a treaty between the
European Central Bank (ECB) and the European System
of Central Banks (ESCB).
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The 18 member Governing Council is the main decision
making body of the ECB.
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Stated goal is to maintain price stability in the euro area (at
inflation rates of below, but close to, 2% over the medium term).
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).
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The key ECB rate is the interest rate on “refinancing operations”
which provide the bulk of liquidity to the banking system.