By Dr. Stephen Williamson
The Federal Reserve System (the Fed) and the European Central Bank (ECB) are of course both central banks. As such, they have a lot in common, but there are some striking differences, in terms of their operational approach to monetary policy, their relationships to the fiscal authorities in their jurisdictions, and in the policy problems they currently face.
As is the case with central banks in most countries, in “normal” times, for example pre-financial crisis, the Fed intervenes in financial markets by targeting an overnight interest rate: the federal funds rate. The fed funds market is somewhat unusual, in that it has thousands of participants, including commercial banks (small and large), credit card companies (e.g. American Express), and government-sponsored institutions (the GSEs are FNMA and FHLMC: Fannie Mae and Freddie Mac). Since late 2008, the Fed also pays interest on reserve deposits held overnight with the Fed, and the Fed also lends to financial institutions at the discount rate, which is set above the fed funds rate. Thus, with the Fed now paying interest on reserves, it essentially operates on a channel system, where the overnight fed funds rate is bounded above by the rate at which the Fed lends short-term, and bounded below by the rate the Fed pays on deposits (reserves).
In normal times, the Fed’s role is, principally, to act as a financial intermediary that issues liquid liabilities – primarily currency, since reserves are normally essentially zero – to finance a portfolio of US Treasury securities. The Treasury securities are typically a mix of short-term Treasury Bills (T-bills) and long-maturity Treasury bonds (T-bonds), with open market operations (and repurchase agreements) in T-bills being the primary means for achieving a daily fed funds rate target. In late 2008 however, this approach changed dramatically.
In response to the events of the financial crisis, the Fed ultimately dropped its fed funds rate target to a range of 0-0.25%, and began paying interest on reserves at 0.25% in late 2008. Further, it embarked on a massive intervention in financial markets, including a large quantity of discount window lending to financial institutions, lending in the commercial paper market, and lending to American International Group (an insurance company) among other things. Most of those interventions have now been unwound, but the Fed’s balance sheet currently reflects two other large, important, and unprecedented interventions, often referred to as “quantitative easing” programs.
Quantitative easing is something of a misnomer, as the actions of a central bank must necessarily always involve the manipulation of quantities on its balance sheet. However, the key idea is that the fed funds rate is currently essentially at its zero lower bound. If the Fed wishes to be more accommodative under these circumstances, it certainly is not feasible to do this by lowering the fed funds rate target. Thus, beginning in early 2009 and continuing until mid-2010, the Fed executed what is now referred to as QE1, the purchase of about $1.2 trillion in mortgage-backed securities (MBS), and about $165 billion in agency securities, i.e. debt issued by the GSEs. While buying GSE debt is not much different than the purchase of T-bonds, since the GSEs were put under government “conservatorship” in fall 2008 anyway, the massive purchases of MBS was an unprecedented intervention by the Fed in private credit markets, in this case the mortgage market. By mid-2010, the Fed’s balance sheet had increased to about $2.4 trillion from about $940 billion in August 2008.
Next, in August 2010, the Fed decided that it would begin replacing MBS and agency securities that were “running off” (due primarily to prepayments on the underlying mortgages in the MBS and maturing agency securities) with T-bonds. Then, in November 2010, the Fed embarked on QE2, a planned purchase of $600 billion in T-bonds with an average duration of about 7 years, to take place over an 8-month period. At this time (mid-April, 2011), it appears that the QE2 program will conclude as planned. The Fed’s balance sheet has expanded to about $2.6 trillion in assets, supported by about $1 trillion in currency and $1.5 trillion in reserves on the liabilities side.
A key feature of the current operating environment of the Fed is that – as in any channel system for monetary policy when the quantity of excess reserves in the system is positive – short term interest rates are determined by the interest rate on reserves (IROR). A complication, which may or may not ultimately matter, is that the IROR is currently set by the Board of Governors of the Fed, but the decision-making arm of the Fed is the Federal Open Market Committee (FOMC) which includes as members the Presidents of the regional Federal Reserve Banks. However, these Fed Presidents have no say in setting the IROR.
One way in which the ECB differs fundamentally from the Fed is that its primary avenue for intervention is not in the overnight market, and it does not seek to target an overnight interest rate. The key tool for the ECB is its main refinancing operations, i.e. the ECB manipulates the total quantity of ECB liabilities primarily by lending to commercial banks in the Euro area through a weekly auction of ECB funds. There are also longer-term refinancing operations, and overnight intervention through the marginal lending facility. The key interest rates set by the ECB are the interest rate on the deposit facility (the counterpart of the IROR in the US), the main refinancing rate, and the marginal financing rate (similar to the discount rate). The main refinancing rate is typically the mid-point in the “channel” formed by the deposit interest rate and the marginal financing rate. The overnight interest rate in the Euro zone is then bounded by the deposit rate and the marginal financing rate, though it tends to fluctuate in that channel substantially. Thus, this is a much different system than Canada’s channel system, for example, where the overnight market interest rate typically deviates little from its target.
As the ECB is the central bank in a currency union, its relationship with the member governments in the Euro zone is quite different from the relationship between the Fed and the US federal government. The ECB holds some debt of the member countries on its balance sheet, but in normal times the composition of that debt by country is determined by a pre-specified formula, and the assets just sit on the balance sheet and are not actively traded in the way the Fed actively trades Treasury debt. Recently however, due to sovereign debt problems, particularly in Greece, Ireland, and Portugal, the ECB has come under pressure to purchase the debt of these countries. Making use of the ECB to monetize the debt of member countries is akin to making use of the Fed to monetize the debt of California or Illinois, for example. While the ECB is secretive about the composition of its security holdings of member-country debt, it appears that the ECB has indeed intervened by purchasing the debt of Greece, Ireland, and Portugal, out of proportion to their sizes.
In terms of monetary policy actions since the onset of the financial crisis, the ECB acted to reduce its policy rates, and narrowed the width of the channel. In August of 2008, the margin between the deposit rate and the marginal financing rate was two percentage points, and the main refinancing rate was set at 4.25%. In May 2009 the width of the channel was set to 1.5 percentage points, with the main refinancing rate at 1%. Recently, the ECB tightened slightly by moving the main refinancing rate to 1.25%. The ECB has certainly not engaged in quantitative easing on the order of what the Fed has. Total ECB assets grew a relatively modest amount from 1.4 trillion Euros in August 2008 to 1.8 trillion Euros in April 2011. Further, the ECB is not holding a large stock of reserves, as is the case with the Fed. In August 2008, the quantity of deposits with the ECB was 90 million Euros, and this grew to 30 billion Euros in April 2011, again a very modest amount relative to what has happened in the US.
In the United States, the Fed faces some very difficult problems. The first quantitative easing program, QE1, was an unprecedented and large-scale intervention in private credit markets. Nothing currently prevents the Fed from, for example, purchasing the debt of General Motors, Chrysler, or any other private corporation, and circumstances could arise where pressure to do so could come from Congress, threatening the Fed’s independence.
With respect to QE2, it is not clear whether this intervention is having any effect, and there is really no solid economic theory to support the notion that the Fed can in fact lower long-term interest rates through QE2, as Fed officials claim. By engaging in QE2, the Fed is effectively transferring interest rate risk from the private sector to itself. Most of the Fed’s assets are now long-maturity, and it is very much in the business of borrowing short and lending long. Should the Fed have to tighten by increasing the IROR, this would cause capital losses on its asset portfolio, which would have to be made up somehow. The Fed could need a capital infusion from taxpayers, or would have to print more money, thus increasing inflation.
The Fed’s key problem will be reducing its very large balance sheet to more normal size while ultimately increasing the IROR to contain inflation. Given the large quantity of reserves outstanding, the potential exists for a large inflation if alternative assets become much more attractive to banks relative to reserves. In its drive to unload reserves to acquire other assets, prices will be driven up, unless the Fed has the resolve to increase the IROR sufficiently quickly. In this respect, the Fed is more constrained than is the ECB. The Humphrey Hawkins Act in the US specifies a dual mandate for the Fed, i.e. Congress dictates that the Fed conduct monetary policy so as to stabilize prices, but the central bank is also supposed to care about real economic activity. The Fed may not have the resolve to contain inflation if the economy is still recovering and if it cares sufficiently about the second part of the dual mandate.
The ECB does not have the Fed’s problems, in that it does not have an inflated balance sheet, and it has already commenced the move to getting its policy interest rates back to normal levels. However, the ECB has a different set of problems, which indeed threaten its existence. There is considerable conflict within the Euro zone concerning the role of the ECB in solving the sovereign debt problems of the member countries, and this conflict seems to have put a smooth transition of power in the ECB in jeopardy.
Dr. Stephen Williamson is Robert S. Brookings Distinguished Professor in Arts and Sciences, Washington University in St. Louis; Research Fellow, Federal Reserve Bank of St. Louis; Academic Visitor, Federal Reserve Bank of Richmond.
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