Money and Banking Lecture 8 2024-2025 PDF

Lecture 8 Money and Banking Dirk Veestraeten References to figures and tables The references to the figures and tables that are used in this lecture can be found at the end of this presentation. -1- Topics Goals o...

Lecture 8 Money and Banking Dirk Veestraeten References to figures and tables The references to the figures and tables that are used in this lecture can be found at the end of this presentation. -1- Topics Goals of Central Banks Structure of Central Banks Independence of Central Banks -2- Price Stability Main current goal of central banks: price stability (i.e., low and stable inflation). Benefits of price stability: 1. Improving transparency of relative prices: prices and thus also relative prices are stable such that planning for firms, consumers and governments is easier (e.g., fewer mistakes are made by (typically) risk-averse entrepreneurs); 2. Reducing distortions of tax and social security systems: if, for instance, tax brackets are not indexed to inflation, a rise in the nominal wage due to inflation may lead to higher taxation although in purchasing-power terms the wage may not have increased (higher nominal before-tax income but maybe even a lower after- tax real income); 3. Preventing arbitrary redistribution of wealth and income: inflation benefits borrowers and worsens the situation of lenders whereas deflation benefits lenders and worsens the situation of borrowers: redistribution of wealth; -3- Price Stability 4. Reducing inflation risk premia in interest rates: remember the Fisher equation where higher expected inflation leads to higher nominal interest rates; 5. Avoiding unnecessary hedging activities: in environments with high and volatile inflation agents may want to hedge against inflation by buying goods, real estate, etc., and thus engage in hedging activities that may not be rewarding from a societal point of view; 6. Increasing benefits of holding cash: lowering of the so-called “shoe leather costs”. -4- Price Stability Empirical evidence: higher inflation produces lower economic growth in the long run (particularly in hyperinflation countries). Hyperinflation: monthly inflation rate > 50 percent. -5- Other (potential) goals of monetary policy High employment or low unemployment (consistent with the natural rate of unemployment) and output stability; Economic growth in the long run; Stability of financial markets; Interest-rate stability; Foreign-exchange market stability. -6- Price stability as the primary goal: theoretical underpinning Long run: no trade off between price stability and other goals (e.g., price stability enhances long-run economic growth as well as financial and interest-rate stability) => no long-run Phillips curve. Short run: trade off between price stability and other goals (e.g., monetary expansion (M  and i ↓) => output  and inflation ) => short-run Phillips curve. It is beneficial to announce the long-term goal of price stability but at the same time there is a temptation for policymakers to stimulate the economy in the short-run (e.g., prior to elections). Time-inconsistency problem: announcing a low-inflation long-run target and at the same time systematically stimulating output in the short run ultimately – in a world with forward-looking agents – leads to high long-run inflation without enhancing economic growth. -7- Time-inconsistency problem Theoretical argument: a good long-run plan but with short-run temptations to deviate from it causes the good long-term plan to become time-inconsistent and then to fail. Illustrating the time-inconsistency problem in monetary policy: The announced long-run goal: price stability; Short-run temptation: expansionary short-term policy to increase output (this produces higher inflation in the short run); Rational agents (workers and firms) are aware of these short-term temptations and subsequently raise their inflation expectations and increase wages and prices accordingly. For instance, unions demand nominal-wage increases to keep real wages constant in view of the anticipation of the above temptations; Production costs and prices rise such that output and consumption do not rise (much). Thus: the increased short-run inflation expectations drive wages and prices up and this generates inflation that ultimately does not stimulate long-term economic -growth. 8- Time-inconsistency problem How to prevent the time-inconsistency problem in monetary policy? Delegate monetary policy to an independent central bank that is isolated from the aforementioned short-run temptations by being obliged to focus on a pre-set behaviour rule to achieve price stability. -9- Behaviour rule and nominal anchor The behaviour rule implies choosing a nominal anchor (or target) to which the central bank commits its policy. Example: “the inflation target is 2%”; This nominal anchor then acts as the basis on which economic agents can form their inflation expectations (that in turn drive current inflation); If the behaviour rule is credible (which is likely with an independent central bank), the time-inconsistency problem is prevented. Typical nominal anchors: the exchange rate, monetary aggregates, the inflation rate (more on this in a later lecture). - 10 - Structure of three central banks The Bank of England (BoE); The Federal Reserve System (Fed); The European System of Central Banks (ESCB). - 11 - Structure of the Bank of England Founded in 1694, the Bank of England is one of the oldest central banks in the world. Main decision-making body: the Monetary Policy Committee (MPC). The MPC meets once every month and consists of 9 members: Governor (Andrew Bailey (since 16 March 2020)) + 3 Deputy Directors + Chief Economist + 4 other members appointed by the Chancellor of the Exchequer. Decisions on monetary policy are made by voting. - 12 - Structure of the Federal Reserve System Main entities of the Federal Reserve System: 1. 12 Federal Reserve Banks (FRB); 2. Board of Governors (BG); 3. Federal Open Market Committee (FOMC). - 13 - The Federal Reserve System - 14 - Federal Reserve Banks: Structure Quasi-public institutions owned by private commercial banks in the district that are members of the Fed system; Bank members in each district elect 6 directors; 3 more are appointed by the BG; 9 directors appoint the president of the bank subject to approval by the BG; 5 of the 12 FRB presidents have a vote in the Federal Open Market Committee (FOMC) – the president of the NY Fed is a permanent member of the FOMC and the other four rotate. - 15 - Federal Reserve Banks: Functions Role in monetary policy: o Holding deposits for banks in their districts (cf. the required and excess reserves); o Administer and make loans to banks in their districts (cf. the lender-of-last-resort function when banks face liquidity problems); o Issue new currency and withdraw damaged currency from circulation; Research: collecting data on local conditions and performing research on topics related to the conduct of monetary policy in order to prepare decision making by the FOMC; Regulator: Supervision and regulation of financial institutions; Providing services to banks: Ensuring the functioning of the payments system. - 16 - Board of Governors: Structure 7 members headquartered in Washington, D.C.; Each member appointed by the U.S. president and confirmed by the Senate; Required to come from different districts; To limit government’s control: 14-year non-renewable term; Chairperson is chosen from amongst the governors and serves a four-year (renewable) term and is appointed by the US president and confirmed by the Senate. - 17 - Board of Governors: Functions Overseeing the operations of the Federal Reserve Banks; Controls the budget of the Federal Reserve Banks; Functions concerning bank regulation: (i) approves bank mergers and applications for new activities, (ii) specifies permissible activities of bank holding companies, (iii) supervises activities of foreign banks operating in the US. - 18 - Federal Open Market Committee 12 members: 7 BG members + president of NY Fed (permanent member) + 4 presidents of other FRB (rotation); Meets eight times a year (about every six weeks); Decides on interest rates and monetary policy and also issues directives to the trading desk at the NY Fed (implementation of monetary policy is centralised). Chairperson: Jerome Powell (also chairperson of the BG) (since 5 February 2018) - 19 - Structure of the European System of Central Banks (ESCB) The structure of the ESCB is fairly similar to that of the Federal Reserve System; European System of Central Banks (ESCB) = European Central Bank (ECB) + 27 National Central Banks (NCB) of the 27 EU member countries; Eurosystem: ECB + 20 NCB of the euro-area member countries (20 EU member countries have adopted the euro as legal tender); Main ECB’s decision-making bodies: o Executive Board (EB): 6 members, responsible for the day-to-day management and implementation of the decisions of the Governing Council by giving instructions to the NCB; o Governing Council (GC): 6 EB members + 20 NCB governors, responsible for decision-making on monetary policy. - 20 - Governing Council 26 members: 6 EB members (President, vice-president and four other members) + 20 NCB governors; Meets every second week at the ECB in Frankfurt (Germany); Decides on key interest rates, reserve requirements and provision of liquidity to the banking system of the euro area; Normally operates by consensus; GC operates on a rotating system of votes; President: Christine Lagarde (since 1 November 2019) - 21 - National Central Banks of the euro-area member countries Implementing monetary policy set by the GC of the ESCB (e.g., providing liquidity to banks in their country via OMO): decentralised implementation of (the main tools of) monetary policy; Ensuring the settlement of domestic and cross-border payments (payments system); Issuing and handling euro notes in their countries; Collecting national statistical data and performing research; Depending on national laws, NCB may be involved in banking supervision and regulation (e.g., the Dutch central bank supervises and regulates the smaller Dutch banks). - 22 - Expanding role of the ECB One reaction of the euro area to the Global Financial Crisis of 2007-2008 and the European Sovereign Debt Crisis (2010-2015): bringing banking policy to the level of the euro area with a central role for the ECB. Main reasons: Strong cross-border interrelations exist between banks within the euro area (ownership, lending, …); National differences can create regulatory concerns as well as differences in the competitive position of banks (guaranteeing a level playing field); Creating clearer mechanisms in order to avoid the (messy and unpredictable) ad- hoc decisions during the Global Financial Crisis and the European Sovereign Debt Crisis; Minimising the need for calls upon the public purse. - 23 - Expanding role of the ECB Achieving these goals led to the creation of the (unfinished) “Banking Union” that will have three pillars: o Single Supervisory Mechanism (SSM, 2014); o Single Resolution Mechanism (SRM, 2016); o European Deposit Insurance Scheme (EDIS, proposed in 2015 but not yet active). - 24 - Single Supervisory Mechanism (SSM, 2014) “Single”: one method across the entire euro area. ECB oversees all “significant” banks in the euro area (other countries can join in “close cooperation”). The other banks are supervised by the national competent authorities, but the ECB takes over supervision if desired. The ECB now supervises 109 banks (out of about 3,500) that account for more than 80% of total bank assets. To qualify as “significant”, the bank is significant in terms of: o size (e.g., assets > €30 billion or > 20% of GDP of the country); o economic importance (e.g., amongst the largest three banks of the country); o sizeable cross-border activities; o receiving direct public financial assistance. - 25 - Single Resolution Mechanism (SRM, 2016) “Single”: one method across the entire euro area. Compulsory in the euro area (other countries can join in “close cooperation”). Goal: predictable restructuring or winding down of banks whilst avoiding calls on the public purse and minimising costs to the real economy. The SRM applies to banks that are under supervision by the ECB (national procedures apply for the smaller banks that are under national supervision). Procedures are triggered by the ECB when the ECB deems that the “bank is failing or is likely to fail” (e.g., the Latvian ABLV Bank and its Luxembourg-based subsidiary on 24 February 2018). - 26 - Single Resolution Mechanism (SRM, 2016) How? o If the bank is still viable but has for instance a large amount of bad assets: Restructuring via the Single Resolution Fund (SRF). This fund should fund restructuring (e.g., removing bad loans from the balance sheet and selling them at a discount, i.e., at a loss covered by the SRF). The SRF is funded via contributions from banks (1% of deposits): € 77.6 in July 2023; o Winding down non-viable banks. In all cases: equity holders, bond holders (senior as well as junior) and deposits over €100,000 will lose. - 27 - European Deposit Insurance Scheme (EDIS) This would become the third pillar of the banking union and was proposed in 2015 by the European Commission. The EDIS would build upon the national Deposit Guarantee Schemes (DGS) and guarantee deposits up to €100,000 (as is currently already the case). Goal: assisting national DGS in the event of “large local shocks” that overwhelm the national DGS and thus further strengthening the safety net for depositors. How? The national DGS and the EDIS together guarantee deposits. This adds confidence and (further) reduces the likelihood of bank runs. - 28 - European Deposit Insurance Scheme (EDIS) Is controversial from a political point of view as euro-area member countries via the EDIS could be called upon when problems arise in one of the other euro-area members countries. E.g., German taxpayers having to rescue depositors in Belgium. Moreover, moral-hazard problems could lead to reduced incentives for adequate supervision at the national level of the euro-area countries. Is not (yet) implemented. Will it ever be implemented? - 29 - Note (no exam material): European Banking Authority (EBA) Closely related to, yet different from the activities of the ECB concerning bank supervision are the activities of the European Banking Authority (EBA, 2011): Mandate: “furthering the single market for the EU banking sector”. Its mandate thus spans the EU and not only the euro area as is the case of the supervisory activities of the ECB. Main activities: o Preventing regulatory arbitrage; o Harmonising bank supervision; o Performing stress tests on EU banks. - 30 - Central bank independence How independent are central banks? What are the dimensions of independence and how are they operationalised? Four dimensions of independence of central banks: 1. Instrument independence: the ability for the central bank to freely set monetary policy instruments; 2. Goal independence: the ability for the central bank to set the goals of monetary policy; 3. Financial independence: the ability for the central bank to determine its own budget; 4. Political independence: the independence of the central bank from political authorities. - 31 - How independent is the BoE? Instrument independence: The government can only overrule the Bank of England and set policy interest rates in “extreme economic circumstances”. Goal independence: The inflation target is set by the Chancellor of the Exchequer. Financial independence: The Bank of England determines its own budget. Political independence: The Governor of the Bank of England is appointed by the Chancellor of the Exchequer (5-year term, renewable). The Bank of England is less independent than Fed and ECB (see below). - 32 - How independent is the Fed? Both instrument and goal independent: The Fed decides independently on for instance the level of the policy interest rates and decides independently on what the inflation and unemployment targets are. Financial independence: independent revenues due to holding securities and loans to banks. Political independence: Fed is structured by legislation from Congress (independent). Also, presidential influence o Through his/her influence on Congress; o Appoints members of Board of Governors; o Appoints chairperson although terms are not concurrent. - 33 - How independent is the ECB? Most instrument and goal independent central bank in the world: The ECB decides independently on for instance the level of the policy interest rates and decides independently on what the inflation target is. Financial independence: The ECB determines its own budget. Political independence: 1. The Eurosystem is not allowed to finance governments. Article 21 of the statutes of the ESCB and the ECB: “… overdrafts or any other type of credit facility with the ECB or with the national central banks in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.” - 34 - How independent is the ECB? 2. The ECB shall not take instructions from political authorities. Article 7 of the statutes of the ESCB and the ECB: “neither the ECB, nor a national central bank, nor any member of their decision-making bodies shall seek or take instructions from Union institutions, …. from any government of a Member State … The Union institutions, … and the governments of the Member States undertake to respect this principle and not to seek to influence the members of the decision- making bodies of the ECB or of the national central banks …”. 3. Security of tenure: appointments are long(er)-term o Executive-Board members: 8-year term (non-renewable) ▪ Removal only in case of “incapacity and serious misconduct” ▪ Appointed by heads of states of all euro-area member countries o NCB governors appointed by national governments for a minimum of 5 years - 35 - Should central banks be independent? Arguments in favour of independence: 1. An independent central bank is more likely to have a stronger focus on longer-run objectives (e.g., price stability) when compared with political authorities: solving the time-inconsistency problem; 2. An independent central bank has larger expertise and is more likely to take hard but necessary measures (and can be used as a scapegoat by politicians); 3. Independence of the central bank avoids the political business cycle (e.g., stimulating the economy in the short run to maximise re-election chances) and monetary policy will not be influenced by potentially changing views on monetary policy within the government; 4. A central bank is less likely to finance budget deficits by directly purchasing government bonds (i.e., by buying them in the primary market). - 36 - Should central banks be independent? Arguments against independence: 1. Undemocratic – lack of accountability (lack of public sanctions). However, regular explanation of policy in Congress / European Parliament. Also, transparency is increasing, for instance, by the (speedier) publication of the minutes. 2. Potential lack of coordination between monetary and fiscal policy (e.g., in the early 1980s as well as in 2017-2018, the US saw a monetary contraction and at the same time a fiscal expansion). 3. An independent central bank must not always operate successfully (e.g., the policies of the Fed during the Great Depression deepened the already dire economic situation). - 37 - Should central banks be independent? We have seen over the past decades a worldwide trend towards central banks becoming more independent. E.g., one of the requirements for entering the euro area (i.e., for being allowed to adopt the euro as legal tender) is to have an independent central bank. Empirical evidence supports this trend (see next slide): larger independence of the central bank => lower inflation. - 38 - Inflation and central bank independence - 39 - Should central banks be independent? A further illustration of the link between central bank independence and (expected) inflation: On the day in 1997 at which the then British Chancellor of the Exchequer, Gordon Brown, announced that the Bank of England would become more independent, long-term interest rates immediately fell by 40 basis points (which in these markets can be seen as a very large sudden movement). This decrease followed from the decrease in expected inflation (cf. the Fisher equation). - 40 - Further expanding the mandate of central banks? In recent years, discussions arose on expanding the mandate over central banks to fields such as encouraging income equality and environmental sustainability. The central bank could then for instance in bond buying programs refrain from buying bonds of firms with a large carbon footprint. Some pros and cons of such expanding mandate for the example of climate change. - 41 - Further expanding the mandate of central banks? Pros: Fighting climate change promotes the public good. For instance, the charter of the Bank of England (BoE) requires the BoE: “to promote the publick good and benefit of our people”; Climate change can affect price stability (e.g., floods that interrupt supply chains and push up prices); Climate change can affect financial stability and maintaining financial stability is one of the goals of central banks (e.g., hurricanes that destroy industries causing banks to be loaded up with bad loans); Central banks have a large “firepower” (think of QE); Central banks have already moved closer to political authorities (think of QE). - 42 - Further expanding the mandate of central banks? Cons: The widened mandate clashes with the lack of (direct) democratic control and accountability: even more policies are shifted to an unelected authority; Credibility, i.e., the perception of independence, of central banks may suffer; Risk of inconsistent policies (e.g., a new government may bring a different focus). Potential conflict with other elements of the mandate as for instance financial stability also presupposes stability of banks with plenty of loans to firms with a large carbon footprint; Should this not be served by the government that has better/direct tools? E.g., directly taxing polluting firms rather than indirectly working via the central banks. - 43 - References to tables and figures All figures, tables, diagrams, etc. are made by Dirk Veestraeten unless stated otherwise. 1. Slide 14: Figure 13.1 on p. 283 of Mishkin, Matthews, Giuliodori (2013), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 2. Slide 19: Picture taken from the website of the Federal Reserve Board (https://www.federalreserve.gov/aboutthefed.htm). 3. Slide 23: Picture from the website of the European Central Bank (https://www.ecb.europa.eu/ecb/orga/decisions/html/cvlagarde.en.html). 4. Slide 39: Figure 13.3 on p. 296 of Mishkin, Matthews, Giuliodori (2013), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. - 44 -