Central banks are generally set up by an act of government. The parliament or congress passes a piece of central banking legislation that establishes a central bank and fully describes its goals, structure, and operating procedures. Since this is a national law that sets up an institution we generally think of the central bank as part of the government. But that does not imply that the central bank’s decisions are determined by the government. That is, it is possible to write a central bank charter that sets up an institution that is largely independent of the president, prime minister, parliament, etc. Of course, it is also possible to set up a central bank that does receive regular input and guidance from one or more members of the current government. The latter bank would not be independent.
Who cares whether a central bank is independent or not? There are some people who believe that politics should not interfere with what ought to be a “scientific” decision about the right amount of money for an economy. We all know that government decisions are full of political compromises. Those who prefer that central banks be independent do not want those kinds of political compromises guiding monetary policy. The history of central banking has found that the worst cases of inflation and hyperinflation have come when monetary policy was co-opted by government policies. This essentially meant that a government that wanted to spend more than it was willing to tax from the citizens was free to print money at will. This kind of temptation and the probability it would be used to cause AD to grow too fast is what appeals to those who prefer an independent central bank.
It is interesting that most important central banks today are independent. The Fed, the ECB, and the Bank of England are all independent. But even in these cases, the public is not always happy about that state of affairs. There have been many times when the public disagreed with central bank policy and was quite vocal in its wishes that the central bank’s policies were more in line with those of the government. In the U.S. when the Greenspan Fed began tightening monetary policy in the late 1990s there was a fear that Fed policy was not compatible with continuing strong economic growth. The “Pro-growth” crowd criticized Greenspan for his overly tight money. Many European politicians suffering through slow growth after 2001 felt that the ECB policies should have been more in line with government desires to see strong AD and real GDP growth. Similar disgruntlement was aimed at the Bank of Japan. Thus we see that short-term political orientation of a government can put plenty of pressure on central banks.
Central banks can be made independent in several ways.
|Point 1||Point 2||Point 3||Point 4||Point 5|
|members of the government cannot attend central bank council meetings or vote on policy issues||members of decision-making bodies serve long terms and otherwise have independence from government influence.||the central bank budget is independent of government financing decisions||the central bank does not have to buy government bonds. This is tantamount to ensuring that the government cannot use the Fed to print money at will||the central bank was created by an act of government and it can be abolished or changed by the same. Some central banks are protected from this kind of action|
So no central bank is TOTALLY independent of the government. It may operate independently but all central bankers know that if they perform especially poorly the independence would be at stake.
Structure and Organization
The Fed and the ECB have very similar decision-making bodies. We purposely do not go into too much detail on this topic and advise that interested students find other courses that are designed for this purpose. There is a centralized governing body in both central banks. The Fed has the Board of Governors in Washington, DC. The ECB has the Executive Board in Frankfurt, Germany. These are relatively small bodies (The Fed has seven and the ECB has six) composed of persons who serve long terms and who are appointed with staggered terms by national governmental officials. They are considered to be monetary “technocrats” – persons who are either economists or bankers or who otherwise are specialists in money and banking.
In both of these central banks there is a main monetary policy decision making body. The Federal Open Market Committee (FOMC) is the Fed’s main decision making body. The ECB counterpart is called the Governing Council. The FOMC and the Governing Council have centralized representation since they contain the members of the Board. They also have decentralized representation because their memberships include the heads of the central banks from all parts of the geography. The U.S. is divided into 12 Fed Districts each with a regional central bank and each with a president of the regional central bank. These 12 regional Fed presidents are members of the FOMC along with the seven members of the board. The euro area is comprised of 13 countries and will be expanded to 15 as of 1 January 2008. The central bank presidents of all participating countries are members of the ECB Governing Council.
The FOMC and the ECB Governing Council each meet regularly (not with each other) and make monetary policy decisions. The central/regional composition and the independence work together to guarantee that monetary policy represents the needs for money throughout the U.S. (for the Fed) and the European Monetary Union (for the ECB). This is important because different regions (in the US) or countries (in the European Monetary Union) may experience different economic trends and business cycles at a given moment. Thus, when the Fed meets in Washington (almost monthly) the specific needs needs of cattle farmers in Texas and the issues of aircraft workers in Seattle can, in principle, be brought up in the discussion. Likewise, when the ECB Governing Council, the German Central Bank president can, in principle, discuss the economy in his country and the president of the Bank of Finland can talk about the latest fortunes of Nokia. In practice, however, this rarely happens and would be frowned upon by the other members of the FOMC. The reason is that, in the U.S. and the European Monetary Union, monetary policy is guided by the needs of the entire area. Since monetary policy controls only the money supply or the interest rate for the entire area, it cannot cater to the demands of individual regions.
The next link takes you to the FOMC site and lets you choose to read the minutes of any of their past meetings. I chose the May 4, 2004 meeting. After several pages of discussion of the overall economy, this is what they decided about their policy agreement. They basically decided to keep policy unchanged and they explained why,
“In the Committee’s discussion of policy for the intermeeting period, all of the members favored maintenance of the existing target of 1 percent for the federal funds rate. It was recognized that the Committee would need to initiate a process of removing monetary policy accommodation at some point, and the recent experience suggested that the time at which policy firming appropriately would commence might be closer than previously had seemed most probable. However, the appreciable rise in real long-term interest rates over the intermeeting period implied that financial market conditions had already tightened on balance. Moreover, the evidence of a significant acceleration in hiring was still limited, and some members referred to the possibility that growth could falter, particularly if market yields were to rise sharply further. With inflation low and resource use slack, the Committee saw a continuation of its existing policy stance as providing a degree of support to the economic expansion that was still appropriate.”
The U.S. Fed has evolved to one in which the Fed Chairman has considerable clout and notoriety. Chariman Alan Greenspan was known around the world and his power was legion. After his retirement from the Fed in early 2006, his successor Ben Bernanke was met with similar respect. The ECB is still young so its history and its president are less powerful both within and outside his own institution. Jean-Claude Trichet became the second ECB president in 2004, taking the reins from the Dutchman, Wim Duisenberg. The eyes of Europe and the world will be on this Frenchman as he attempts to influence and lead policy.
Readings that cover the structure and operation of the U.S. Fed:
The above reading was taken from the web site of the Federal Reserve Bank of San Francisco. If you want to go directly to the source, use the following link:
Readings about the European Central Bank:
For more elaboration, see the larger document at : http://www.ecb.int/pub/pdf/other/monetarypolicy2004en.pdf