The Structure of Central Banks

Chapter 16

Central Bank Independence

Central bank would like low inflation expectations. However, government may have short-term incentive to expand liquidity to boost short-term economic growth. Especially during periods when short-run popularity is crucial such as elections. May be difficult to establish credibility of a low inflation strategy and persuade people to have low inflation expectations. Society should design the state such that central bank is able to resist the short-run imperatives of government.

Principles of Central Bank Design

1. Independence: Central Bank must be insulated from direct political influence.
Strategies for Insulation Policy Independence: Central Bank sets day-to day monetary policy free of direct government control. Policy not reversible. Personal Independence: Long-terms of Office for Central Bank Policymakers, difficult for Central Bankers to be Fired. Revenue Independence: Central Bank has independent sources of revenue.

Independence of US Federal Reserve

Policy Independence: Monetary policy set by directors of Federal Reserve of USA controlled & Regional Bank Personal Independence: Chairman of Fed serves across Presidential terms. Presidents appointed by executive and approved by legislature. Other policymakers serve terms of either 5 or 14 years. They cannot be fired without votes of of Congress. Revenue Independence: Fed earns profits through its payment operations which constitute its budget.

Formation of a New Currency

The countries of Euroland needed to replace national central banks with a single policy maker. Treaty developing the ECB used modern best principles of central bank.
11 Countries (in blue) adopt a single currency in 1998, 13 countries by 2007.

Independence of ECB
Policy Independence: Monetary policy of ECB controlled by Executive Council & National Bank Presidents. Decisions cannot be reversed by national governments. Personal Independence: National Bank managers serve 5 year terms across Presidential terms. Board members serve 8 year terms. Revenue Independence: Budget provided by national central banks which conduct most profitable operations

Independence of Bank of Japan

Policy Independence: Monetary policy set by board. Personal Independence: Governor and Board members have terms of five years, appointed by Cabinet approved by Diet and House of Councillors. Budgetary Independence (?): Ministry of Finance must approve budget.

Trend toward Independence

1998: Bank of Japan removed from direct control of Ministry of Finance. 1998 Bank of England removed from direct control of the Chancellor of the Exchequer. In 2003, Bank of Korea removed from direct control of Ministry of Economy and Finance.

Independence of the HKMA?

HKMA Policy Objectives
The HKMA is an integral part of the Hong Kong SAR Government. The Chief Executive , appointed by the Financial Secretary, remains a public officer. The Exchange Fund Advisory Committee functions as a management board of the HKMA. The HKMA is accountable to the public through the Financial Secretary.

Exchange Fund controlled by Financial Secretary. Decision to continue or abandon exchange rate peg lies with Financial Secretary. Existence & Convertibility of HK dollar written into the Basic Law. HKMA has control over its own budget.

Hong Kong Monetary Authority

HKMA formed in 1993 with merger of Exchange Fund and Commissioner of Banking to perform role of the central bank.

1. Regulation of the Banking System 2. Operation of the System of Payments 3. Control of the Monetary Base
Prior to 1988, interbank settlement done on the books of HSBC

Monitoring the Monitors

Reducing the impact of short-term political considerations on decision making is important. But its also important in long-term to insure that central bank serves goals of society and not own self interest. Buiter Cognitive Capture by Wall Street of FED.

More Principles of Central Bank Design How to monitor the central bank.
2. Decision Making by Committee Power should be diffuse within the central bank. 3. Accountability and Transparency Banks should make information about their intentions and actions. 4. Policy Framework Banks should have a clear guideline for setting their policy which meets the consensus of society.

Decision Making by Committee

Interest Rate Setting
Each of the Big 3 central banks sets a key interest rate by committee. The decisions of these committees are closely watched. Bank Fed ECB BoJ Committee Federal Open Market Committee Governing Council Monetary Policy Committee Rate Fed Funds Rate Main Refinancing Operation Rate Uncollateralized Overnight Call Money Rates

Nominal Anchor
A specific nominal variable (i.e. measured in money) that the central bank might specify to govern the expansion of money/liquidity in the economy. Monetary Aggregates: M1, M2, M3 Inflation Rates Exchange Rates

Accountability and Transparency

Publication of Policy Minutes
Fed: Minutes ECB: Doesnt Publish Critique BoJ Minutes

Data, forecasts other research materials, presentations to public and legislature.

Federal Reserve must present report to Congress twice per year.

Policy Framework
Fed Objective Humphrey Hawkins Act (1978): Fed instructed by Congress to be conducting the nation's monetary policy .. in pursuit of maximum employment, stable prices, and moderate long-term interest rates ECB Objective The primary objective of the ECBs monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term. Japan Objective: Bank of Japan Act Article 2 Currency and monetary control by the Bank of Japan shall be aimed at achieving price stability, thereby contributing to the sound development of the national economy

Harmonised Index of Consumer Prices (HICP) Inflation in Euroland

Inflation Targeting
A growing number of central banks, beginning in New Zealand in the 1980s conduct monetary policy under the framework of inflation targeting Bank states an explicit target for inflation and publishes inflation forecasts under current conditions. Policy is set in order to bring actual inflation within a range around the target. Central bankers are judged by their ability to hit target and repeated failures may result in policymakers losing their jobs.

Characteristics of Inflation Targeting Regimes

1. The public announcement of medium term numerical targets for inflation. 2. An institutional commitment to price stability as the primary goal of monetary policy. 3. An information-inclusive strategy to set policy instruments. 4. Increased transparency of the monetary policy strategy. 5. Increased accountability of central bank for obtaining the inflation objective.
Msihkin Can Inflation Targeting Work in Emerging Market Countries?

List of Inflation Targeting Countries

Rose
A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed

Six Foundations of Monetary Policy Strategy

1. 2. 3. 4. 5. 6. there is no long-run tradeoff between output (employment) and inflation; expectations are critical to monetary policy outcomes; inflation has high costs; monetary policy is subject to the timeinconsistency problem; central bank independence helps improve the efficacy of monetary policy; a strong nominal anchor is the key to producing good monetary policy outcomes.
Mishkin Monetary Policy Strategy: How Did We Get Here?

Nominal Anchor
A specific nominal variable (i.e. measured in money) that the central bank might specify to govern the expansion of money/liquidity in the economy. Monetary Aggregates: M1, M2, M3 Inflation Rates Exchange Rates

Nominal Anchor
HKMA satisifies only 1 out of 3 characteristics of central bank independence. Central banks without independence may choose some other constraint on their ability to increase the money supply, called a nominal anchor. During the 19th and early 20th century, most countries kept their currencies pegged to a fixed amount of precious metal (gold or silver). Inflation was slow during this period.
If the central bank increases the money supply rapidly, money would drop in value relative to precious metals and their price would soar.

The exchange rate peg can also work as a nominal anchor.

History of Hong Kong Monetary System

1841: 1862 Multiple currencies used in Hong Kong. 1863: 1935 Silver Standard: Hong Kong banks issue dollar notes backed by silver bullion. 1935: 1972 Sterling Standard: Hong Kong banks issue dollar notes backed by UK pounds. 1972: 1974 Fixed Exchange Rate with US dollar 1974:1983 Floating Exchange Rate 1984: Today - Linked Exchange Rate System

Floating exchange rates & Inflation

Average Inflation Rate

9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% 1961-1973 1974-1983 1984-2003