International financial economics

The European Central Bank ECB and the Federal Reserve the Fed: differences and similarities in setup, operational procedure, and monetary policy Akmal Rahimov Hari Widodo Yudha Hadiy

The European Central Bank (ECB)

and the Federal Reserve (the

Fed):

differences and similarities in

setup, operational procedure, and

monetary policy

Akmal Rahimov Hari Widodo Yudha Hadiyanto

International Financial

Economics

OUTLINE:

• PART I : General Overview, Historical

Background, Organizational Structure,

Main Functions and Tasks of the Federal

Reserve and ECB

• PART II : Differences and similarities in

Operational Procedures of Federal

Reserve and European Central Bank

• PART III : Monetary Policy

PART I:

General Overview, Historical Background, Organizational Structure, Main Functions and

Tasks of the Federal Reserve Bank

and European Central Bank (ECB)

The Role of Central Bank

Why the US need a central bank?

1 The United States lacked a central bank until the twentieth century

2 Needs a money manager, to handle the nation's financial system

3 Financial panics, the Bank Panic of 1907 convinced the public that a central bank was necessary

Why the US need a central bank?

(Continued)

4 To reform the financial system to be more

integrated and secure in supporting the

developing economy.

5 In 1913, after considerable debate, Congress passed the Federal Reserve Act to balance the financial needs of the country

Why European System of Central Bank

(ESCB) is needed?

1 Primary objective : to maintain price stability, as

defined in Article 2 of the Statute of the ESCB and of the ECB

2 Price stability : a year-on-year increase in the

Harmonized Index of Consumer Prices (HICP) for

the euro area of below 2% To be maintained over

the medium term

3 The Governing Council announced that, in the

pursuit of price stability, it would aim to maintain

inflation rates close to 2% over the medium term.

Historical Background

FEDERAL RESERVE

 Drafted by Congress as the

Federal Reserve Act in 1913

 The act began in 1908, when

Congress set up the National

Monetary Commission to

pinpoint weaknesses in the

nation’s financial system

 Triggering Factors : Monetary

panic

(Bank commitment)

 The commission found that

the United States lacked a

reliable method to provide

liquidity to the money supply

EUROPEAN CENTRAL BANK

 Established on 1 June 1998, as one of the world’s youngest central banks

 Triggering factors : the presence

of EMU (political decision), i.e to maintain price stability

 EMU:

o Stage 1: Restriction on the

movement of capital were abolished (1990)

o Stage 2:Establishment of EMI

and ECB

o Stage 3:Irrevocable fixing of

exchange rate

Historical Background(Continued)

Wilson signed the

Federal Reserve Act

into law on Dec 23,

1913, to help to

maintain a stable,

healthy and growing

economy.

◊ The legal basis : the Treaty on

European Union signed on February 7, 1992 in Maastricht which established the European Community

◊The ESCB is composed of the

ECB and the national central banks of all 15 EU Member States

Stages to Monetary Union

1 Maastricht Treaty

2 Establishment of the EMU

3 Irrevocable fixing of exchange rates

Inseparable Story: EMU and the

ECB Stage 1: Maastricht Treaty

1 1 July 1990, the first stage : movement of capital

among the European Economic Community (EEC)

countries should be demolished the committee of

governors decided to facilitate the preparatory work

for the establishment of EMU (the Treaty of Rome)

2 1991 intergovernmental conference agreed to revise

the Treaty of Rome in order to establish the required

institutional structure Represented on the Treaty on

European Union, signed in Maastricht on February 7,

1992

Stage 2 : Establishment of the

EMU

1 1 January 1994 : The establishment of the

European Monetary Institute (EMI) The EMI had

no responsibility for the conduct of monetary policy

in the European Union

name the European currency unit to be introduced

the "euro" , and confirmed that Stage Three of EMU would start on 1 January 1999

Council, and subsequently to the public, the selected design series for the euro banknotes to be put into circulation on 1 January 2002

4 25 May 1998 : the governments of the

11 participating Member States

( Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the

Netherlands, Austria, Portugal and

Finland) appointed the President, the Vice-President and the four other

members of the Executive Board of the ECB

• With the establishment of the ECB on 1

June 1998, the EMI had completed its tasks The EMI went into liquidation on

Stage 3: Irrevocable fixing of

exchange rates

 1 January 1999 : the irrevocable fixing of

the exchange rates of the currencies of the

11 Member States initially participating in Monetary Union was commenced along

with the conduct of a single monetary

policy under the responsibility of the ECB

 1 January 2001 : Greece joined the EMU,

making the number of participating

Member States increased to 12

Basic Tasks of Federal Reserve and European Central

 serves as the banker for

the federal government by

providing financial services

for the U.S Department of

the Treasury

 supervises and regulates a

large share of the nation's

banking and financial

system;

 administers banking and

European Central Bank

 To define and implement monetary policy in Euro area

 To maintain price stability and conduct foreign

exchange operations

 Holding and manage the official foreign reserves of the Member States

 Promote the smooth operation of payment systems

 Provide prudential supervision of credit institutions and the stability

Independence of the Central Bank

The ECB:

Based on the Maastricht

Treaty, neither ECB nor NCB

nor any member of

decision-making bodies are allowed to

seek or to take instructions

from community institution or

bodies form any government

of any member states or from

any other bodies

Structure of the System of Federal

Reserve Board of Governors of the Federal Reserve

Board of Governor of The Fed

1 Seven-member Board of Governors

2 Appointed by the President of the United States and confirmed by the Senate

3 Serve 14-year terms, arranged so that one expires in every

even-numbered year designed to be long enough to prevent day-to-day

political pressures

4 The President of the United States designates a Chairman and Vice Chairman from the Board to serve four-year terms.

Federal District Bank (12)

 District Banks There are 12 Federal

Reserve Districts, or regions, throughout the United States Regional headquarters are located in Boston, New York,

Philadelphia, Cleveland, Richmond,

Atlanta, Chicago, St Louis, Minneapolis,

Kansas City, Dallas, and San Francisco

Additionally, there are Branches of

Reserve Banks in 25 other cities

12.San Francisco

Federal Open Market Committee

1 The Federal Open Market Committee (FOMC) consists of

2 Nonvoting Reserve Bank presidents attend the meetings

of the Committee, participate in the discussions, and

contribute to the Committee's assessment of the

economy and policy options

Federal Open Market Committee

The FOMC has the primary responsibility for

conducting monetary policy

Director of each Reserve Bank contributes to

monetary policy by making recommendations

about the appropriate discount rate

Member Banks

National banks chartered by the federal government are, by law, members of the Federal Reserve System State-chartered banks may choose to become

members of the Federal Reserve System if they meet the standards set by the Board of Governors

Advisory Committee

The Federal Reserve System uses advisory and working

committees to advise the Board of Governors directly:

• Federal Advisory Council

Consists of one member—traditionally a commercial

banker—from each Federal Reserve District.

Required by law to meet four times each year with the

Board of Governors to discuss economic and banking

matters.

• Consumer Advisory Council

This statutory council has thirty members, meets with the

Board three times a year on matters concerning consumers and the consumer credit protection laws administered by

the Board Consists of academics, legal specialists in

consumer matters, and members representing the interests

of consumers and the financial industry.

• Thrift Institutions Advisory Council

Board of Governors established this council to obtain

information and opinions on the needs and problems

of thrift institutions The council is made up of representatives

of savings and loan associations, savings banks, and credit

unions

Flow of Command in the FED

Federal Open Market Committee

(Board of Governors and 5 Federal Reserve bank presidents)

• Directs open market operations, which is the primary instrument of monetary policy.

Federal Reserve banks (12 districts)

• Propose discount rates.

• Hold reserve balances for depository institutions and lend to them at the discount window.

• Sets reserve requirements and approves

discount rates as part of monetary policy.

• Supervises and regulates member banks and

bank holding companies.

• Establishes and administers protective

regulations in consumer finance.

• Oversees Federal Reserve Banks.

Advisory Councils

Exercises General Supervision Advise

Compose

2 The main responsibilities of the Executive Board are: The main responsibilities of the Executive Board are:

to give the necessary instructions to the NCBs;

delegated to it by the Governing Council of the ECB

ECB

Governing and General Council

1 The Governing Council is the supreme

decision-making body of the ECB which comprises the

members of the Executive Board of the ECB and the governors of the national central banks which have adopted the euro

2 Only members of the Governing Council present in person shall have the right to vote

bodies of the ECB It comprises the President and the Vice-President of the ECB and the governors of all 15

EU national central banks

PART II:

Differences and similarities in

Operational Procedures of Federal Reserve and European Central

Bank

Operational Procedure

Operational Procedure is the set of instruments and

procedures which a central bank uses to steer interest rate, signal monetary policy intentions, and manage

liquidity in the money market

Operational Procedures related to the monetary policy and the instruments used such as open market

Operation, standing facilities, and reserve requirement

Monetary Policy Framework

ECB:

• Primary objective of ECB is

maintaining the price stability.

• Operationally defined as

controlling inflation to be less 2% in Harmonized Index Consumer Prices (HICP).

• In evaluating the financial

market condition, (M3) as quantitative reference

• Prediction of inflation and

the risk price stability is crucial (broad based

assessment)

• controlling inflation and

promote economic growth

• There is no exact figure as

reference of the price stability and inflation.

• Board of Governor and

FOMC maintain growth of money and credit in line with the long-run economic performance such as

employment rate, inflation rate, and moderate interest rate.

Monetary Policy Framework

• ECB announces target of

money growth periodically

since its inception

• Using M3 as the evaluation

tool to the financial market

condition has some

technical problem

• M3 is defined as currency,

deposits, and marketable

securities held by

Euro-area resident

• The fed has been

announcing the target of money growth since 2002.

• The Fed does not have such

kind of problems

Operational Procedure :

Both central banks use the similar tools but

different method in managing money market and

influencing short-term interest rate

1 The ECB influence the liquidity in

the market through the open

market operation based on

weekly pre-arranged schedule

The instrument used in this

operation is essentially

repurchase agreement like in the

Fed

2 ECB uses minimum reserve to

stabilize money market interest

rates The ECB requires bank to

hold required reserve based on

the level of the liabilities

1 The Fed uses the Open Market Operation through over-night repurchase agreement in influencing market liquidity and the two other tools, i.e reserve requirement and discount rate Level of supply is determined every morning based on forecast for reserve demand.

2 Reserve requirement is not used

to influence inflation and growth, but to stabilize the demand for reserve to make easier to control the fed fund rate.

Operational Procedure :

loans to banks with the

marginal lending rate The

spread is determined by

governing council.

operations are done

4 Estimate the demand for reserves, and estimates the supply before any other open market operation, and arrange additional open market

operations.

5 The Fed conducts the OMO through the Fed of NY and involving a fewer financial institution.

Operational Procedure :

6. Due to the differences in

financial structure among

the countries, ECB deals

with more various

collateral

7 The sheer volume of funds

that is refinanced on

regular basis is larger than

that of the Fed therefore

ECB set up more

cumbersome and risky

6.The Fed only deals with the

US government securities

as collateral

PART III: Monetary Policy

 Macroeconomic Performance

 Monetary Policy Instruments

 Monetary Policy Strategies

Key economic characteristics of the Euro Area, US and Japan

Unemployment rate in the Euro Area, the United States and

Japan

Monetary Instruments

Tools of Monetary Policy of Federal Reserve

and ECB

The instruments of ECB’s monetary policy

1. Open market operations

 The main refinancing operations are

regular liquidity-providing reverse

transactions with a weekly frequency and

a maturity of two weeks

 The longer-term refinancing

operations are liquidity-providing

reverse transactions with a monthly

frequency and a maturity of three

months

The instruments of ECB’s monetary policy

 Fine-tuning operations can be executed on

an ad hoc basis with the aim of both

managing the liquidity situation in the market and steering interest rates, in particular in

order to smooth the effects on interest rates caused by unexpected liquidity fluctuations

 In addition, the Eurosystem may carry out

structural operations through the issuance

of debt certificates, reverse transactions and outright transactions

The instruments of ECB’s monetary policy

2. Standing facilities aim to provide and

absorb overnight liquidity, signal the general monetary policy stance and bound overnight market interest rates

 Marginal lending facility , is used by

counterparties to obtain overnight liquidity from the NCBs against eligible assets

 Deposit facility to make overnight deposits

with the NCBs.

The instruments of ECB’s monetary policy

3 Minimum reserves

 The Governing Council of the ECB has decided

to apply minimum reserves as an integral part

of the operational framework for the monetary policy in Stage Three

Three Tools of Federal Reserve

Monetary Policy

proportion (percentage) of bank deposits they must keep on deposit at the Fed.

the percentage of bank deposits kept in

non-interest bearing deposits at the Fed and limits

bank lending.

percentage of bank deposits kept in the Fed and provides the banking system with excess

reserves.

clear checks and to satisfy reserve requirements.