Comparison of ECB and Fed

Comparison of European Central Bank and US Federal Reserve System 1 Introduction On 1 January 1999 the euro was established as the single currency of 11 European countries with 16 members today. Since January 1999 the European Central Bank (the “ECB” hereafter) is responsible for the single monetary policy in the Eurosystem, which represents the central banking system of the euro area.

The main aim of this paper is to provide the analytical comparison of the Eurosystem and the Fed. First, we illustrate some of the main similarities and differences in the actual behavior of the institutions, examining the different environments in which they carry out their tasks. Second, we evaluate the monetary policy rules for them to ascertain whether the responses of these central banks to their contingent economic factors differ and, if so, by how much.

Third, central banking practices have evolved around the world: we highlight some areas in which there might be some disparity between the legislative framework and the actual practices − i.e. the de jure aspects as well as the de facto aspects. This paper is organized as follows. Section 2 compares the institutional structures, monetary policy frameworks and objectives of the central banks, and then discusses the issues of independence, accountability,

transparency, communication and strategy. Section 3 contains an overview of the environment in which the central banks operate. Section 4 provides final analysis of evidence provided in previous sections and conclusion whether we reached our main goal of proving ECB's higher level of independence or not. 2 The institutional structures and monetary policy framework 2.1 Organizational framework and institutional features of the central banks

The Maastricht Treaty (henceforth the “Treaty”) contains the institutional arrangements for the conduct of monetary policy in Economic and Monetary Union (EMU) in Europe. The Treaty, which entered into force in November 1993, provides the legal basis for the formation of the European System of Central Banks (ESCB), which comprises the ECB and the national central banks (NCBs) of the 25

Member States of the European Union (EU). The term “Eurosystem” denotes a subset of the ESCB that comprises the ECB and the NCBs of those EU Member States that have adopted the euro. The governing bodies of the Eurosystem are the Governing Council and the Executive Board. The latter consists of the President, the Vice-

President and four board members. Its main task is to implement the decisions of the Governing Council, which currently consists of the Executive Board members plus the 16 governors of the euro area NCBs (see Figure 1). While the members of the Executive Board are appointed for a non-renewable eight-year term, the terms of office of

NCB governors range between five and eight years. Figure 1 Organizational Framework of the Eurosystem . . Source: Gerdesmeier, Lichtenberger and Mongelli (2004). The institutional arrangements of the Eurosystem in some ways resemble those of the Fed (see Figure 2). Goodfriend (1999) observes that both the

Fed and the Eurosystem are federal central bank systems. The Fed became more centralized with the Banking Act of 1935. For its part, the ECB has in principle a role similar to that of the Fed’s Board of Governors, while the 16 NCBs of the Eurosystem play a role similar to the 12 regional Federal

Reserve Banks in the US. In a similar fashion the President of the ECB chairs the Governing Council meetings in much the same way as the Chairman of the Fed’s Board of Governors chairs the meeting of the Federal Open Market Committee (FOMC). In the euro area, the Governing Council is responsible for formulating the monetary policy of the euro area, a task that is

carried out by the FOMC in the US. The members of the Fed’s Board of Governors are appointed for a fourteen-year term, i.e. nearly twice as long as the eight-year term foreseen for the members of the ECB’s Executive Board. However, both terms are non-renewable. The Chairman and Vice-Chairman of the Board of Governors instead both serve for a four-year term.

These terms may be renewed as long as their term within the Board has not expired. However, in practice the previous Chairman served over eighteen years as that he had originally been appointed to serve out the unexpired term of his predecessor. While there are many similarities in the structures of the Eurosystem and the Fed, there are also some key differences.

One difference concerns the voting rights. Currently all NCB governors have an equal vote in all policy decisions taken by the Eurosystem Governing Council. Participation in FOMC voting, by contract, is more restricted: all seven members of the Board of Governors of the Federal Reserve System have a permanent voting right, as does the President of the

New York Fed, whereas the Presidents of the Chicago and Cleveland branches alternate annually, and the other nine reserve bank presidents share only four votes on a rotating basis (however, they do attend all FOMC meetings and participate in discussions even when they cannot vote). Figure 2 Organisational Framework of the Federal Reserve System Source: Pollard (2003). While monetary policies in both areas are currently based

on a collective decision-making system ─ i.e. by the respective (monetary policy) committees – there may be some more de facto differences in how these committees operate. Blinder (2004) observes that not all committees are characterised by the same status. A collegial committee prizes solidarity and strives for group ownership of its decisions. The chairman forges consensus and, where possible, seeks to achieve unanimity in the decision-making

process. Conversely, in an individualistic committee, differences of opinion (if any) are voiced and conclusions are reached by majority voting, if necessary. Hence, individual members are allowed to express their preferences and do not always have to embrace the group’s decisions. When taking monetary policy decisions, both the Governing Council and the Board of Governors officially act by simple majority voting.

In practice, both the Governing Council and the FOMC operate as collegial committees. However, according to Blinder, the former functions as a genuinely collegial committee practicing consensus voting, whereas, within the latter, the former chairman was able to steer the agenda very tightly. In addition to the monetary policy function, both central banks perform a number of other functions and tasks. 2.2 Monetary policy objectives The Treaty states that “the primary objective of the

ESCB shall be to maintain price stability” and that “without prejudice to the objective of price stability, the ESCB shall support the general economic policies of the [European] Community with a view to contributing to the achievement of the objectives of the [European] Community”. The objectives of the Community are inter alia to ensure “a high level of employment […], sustainable and non-inflationary growth, a high degree of competitiveness and convergence of economic

performance”. The Treaty thus establishes a clear hierarchy of objectives for the ECB and assigns overriding importance to price stability. Moreover, the ECB has made public its precise quantitative definition of price stability. The ESCB’s mandate to pursue price stability contrasts with the Fed’s multiple-objective mandate. The latter’s mandate states that “the

Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the country’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates” (Federal Reserve Act, Section 2A.1). Against this background, it is worth noting that

Goodfriend (1999) finds that although the US Congress has not assigned an explicit mandate to pursue low inflation, the Fed seeks to educate the public about the benefits of low inflation and the need to preempt it. Hence, the Fed’s policymakers seem to assign at least an implicit ranking to these goals, although in the long run all three are compatible. It has been argued that despite its multiple objectives, the

Fed has traditionally placed more emphasis on achieving price stability and, in recent years, there have been calls for a clearer price stability mandate for the Fed (see Wynne, 1999 and Bernanke, 2003a). 2.3 Central bank independence In many countries the gradual process of shifting responsibility from an individual central banker to a monetary policy committee has coincided with granting independence to the central bank (Blinder,

2004). Central bank independence is a multi-layered concept with several elements, including: personal independence, which pertains to the influence of the government in the appointment process, the duration of the terms of office, and dismissal procedures; financial independence, which concerns the separation between the finances of the government and of the central bank, as well as the setting of the bank’s budget; and functional independence, which is also referred to as policy independence, and is related

to the autonomy in formulating and executing monetary policy. The latter is further articulated into independence in terms of goals and in terms of instruments. Article 108 of the Treaty establishes that the Eurosystem is independent from any political influence. Four main provisions safeguard the independence of both the Eurosystem and its decision making bodies. First, the

ECB’s financial arrangements are kept separate from the financial interests of the European Community. The ECB has its own budget, and its capital is subscribed and paid up by the euro area NCBs. Second, potential political influence on individual members of the ECB’s decision-making bodies is minimized: the members of the Governing Council are endowed with relatively long mandates, while a rule stipulates that members of

the Executive Board cannot be reappointed. Third, the Eurosystem’s independence is strengthened by the prohibition laid down in the Treaty of any provision of central bank credit to the public sector. Finally, the Eurosystem is also functionally independent. The ECB has at its disposal all the instruments and competencies necessary to conduct its monetary

policy and is authorized to decide autonomously how and when to use them. While the Fed enjoys significant independence, it has been argued that this is somewhat lower. While the Congress has delegated shaping the Federal Reserve Act was also to keep politics out of monetary policy. There are a number of provisions designed to safeguard the independence of the

Fed. For example, the Fed is independent of other branches and agencies of the government. It is self-financed and is, therefore, not subject to the congressional budgetary process. The terms of the seven members of the Board of Governors, who are nominated by the President and confirmed by the Senate, span multiple presidential and congressional terms, as a full term lasts fourteen years. In practice this can be even longer as, although a member who has served

a full term may not be reappointed, a reappointment is possible for a member who has completed an unexpired portion of a term. The Chairman and Vice Chairman of the Board are chosen by the President from among the sitting governors and must be confirmed by the Senate. They serve terms of four years and may be reappointed as Chairman or Vice Chairman until their terms as governors expire.

Some further differences among the central banks also exist in terms of exchange rate policies. In the US, foreign exchange policy is fully in the hands of the Treasury Department. As far as the euro area is concerned, Article 111 of the Treaty gives the Council – acting either on a recommendation from the Commission and after consulting the ECB, or on a recommendation from the

ECB – the right to formulate “general orientations for exchange rate policy”. At the same time, the Treaty also contains provisions which ensure that the pursuit of the objective of price stability is fully respected by the single exchange rate policy (ECB, 2004). Overall, the Eurosystem is one of the most independent central bank systems in the world. However, this must be set against the increasing desire on the part of the public for transparency

(as Eijffinger and Geraats, 2002 observe). This brings us to our next point, namely the importance of institutional features for central banks. 2.4 Accountability, transparency and communication Goodfriend (1999) observes that in the early 1980s under the Chairmanship of Paul Volcker, the Fed realized that bringing down inflation and maintaining it at a low level would be easier if the Fed had the necessary credibility in terms of being committed to fight

for low inflation. Fed officials considered communication with the public a useful tool for building credibility. In the same vein, Woodford (2003) points out that transparency may help enhance the effectiveness of monetary policy. However, this may create a potential conflict for central banks: a maximum level of transparency may not be optimal and could lead to less clarity and common understanding (see Kahnemann, 2003, Mishkin, 2004 and Ehrmann and Fratzscher,

2005). In this sub-section we briefly compare the three central banks with regard to accountability, transparency and communication. 2.4.1 Accountability To retain legitimacy, an independent central bank must be accountable to democratic institutions and to the general public for its actions in the pursuit of its mandate. The Treaty lays down a number of reporting requirements for the

ECB − for example, the presentation of an Annual Report to the European Parliament, the Commission and the EU Council − and establishes the need to make regular presentations to the European Parliament to ensure accountability (see ECB, 2004). Similar reporting procedures have been laid down in the

US. The Fed is ultimately accountable to the Congress, which can amend the Federal Reserve Act legislation at any time. The Fed must report once a year on its activities to the Speaker of the House of Representatives, and twice a year on its plans for monetary policy to the Congress’ banking committees. Fed officials also testify before the Congress when requested. 2.4.2 Transparency Transparency is a concept that is closely related to, yet

distinct from, accountability. The transparency of monetary policy can be defined as the extent to which central banks disclose information related to the policymaking process. In the words of Blinder (2004), such information should be clear, have a substantive content and be open to public scrutiny. The boundaries of transparency vis-à-vis accountability and communication vary according to authors. Eijffinger and Geraats (2002) distinguish between five types of transparency,

namely: • political transparency, which refers to openness about policy objectives and consists of being clear about the formal objectives of monetary policy; • economic transparency, which focuses on the economic information that is used for monetary policy (including economic data, policy models and forecasts); • procedural transparency, which reflects the way monetary policy decisions are taken. This involves an explicit monetary policy rule or strategy that describes the monetary policy framework;

• policy transparency, which means that policy decisions should be promptly announced. In addition, it includes an explanation of the decision together with a policy inclination or indication of likely future policy actions; and finally, • operational transparency, which concerns the implementation of the central bank’s policy actions. Concerning the Eurosystem, Winkler (2002) notes different aspects of transparency that have been receiving greater

attention, including openness, clarity and information efficiency. He, however, warns that an effective approach to communication requires a balance to be struck between being open about the complex nature of policy making, and simplifying the presentation of this process in the interest of greater clarity. Blinder (2004) also notes that monetary policy decision making cannot be conducted in a completely open fashion. According to

Trichet (2004), both the Eurosystem and the Fed place strong emphasis on ensuring the transparency of the decision-making process and the transparency of the analyzes made by the responsible decision-making “college”. Moreover, transparency also characterizes both institutions in terms of the explanations of the economic diagnosis provided to the public and to market participants, with all the decisions being released in real time. Concerning clarity, the publication of a precise quantitative definition

of price stability by the ECB – as opposed to the Fed’s practice – may be seen as a component of both transparency and accountability, as it provides the public with a yardstick against which the performance of the ECB can be measured. For the ECB, the Introductory Statement at each ECB press conference shortly after the first Governing Council meeting each month represents a means of almost instantaneously announcing and explaining

the most recent monetary policy decision. Similarly, the current practice of the FOMC is to announce policy changes as soon as they are made. Immediately after each meeting, the FOMC issues a statement to the effect that a decision has been taken to lower or raise rates, or, in case the decision was to leave rates unchanged, merely noting that the meeting has ended. The FOMC also publishes the minutes of each meeting three weeks later.

It has been argued that the publication of minutes makes the Fed more transparent than the ECB. The main reasons why the ECB currently abstains from publishing minutes are twofold. First, the ECB intends to communicate to the public that the entity which decides is not a personality − or a group of personalities − but rather a college (i.e. a united team which benefits

from its collegial wisdom). Second, the ECB does not want to convey the impression that it is a place where various national interests, as represented by various NCB governors, can be reconciled. In fact, the Treaty clearly requires decisions to be taken in the interest of the euro area as a whole, and thus any kind of reasoning on the basis of a national vision is excluded. This makes the situation in the euro area somewhat different from those of the

US or Japan. In any case, the ECB publishes its “diagnosis” in real time, so that all the arguments that led to the decision are presented in full to the public. Several recent studies have shown the ECB to be highly predictable in its decisions, which is one of the ultimate goals of transparency. Furthermore, as several authors have pointed out, decision-making by committees also implies that statements by individual committee members is increasingly relevant

(see Amato et al 2002, Blinder 2004 and Chappel et al 2004). Ehrmann and Fratzscher (2005) analyse the communication strategies of the Fed and the Concerning dispersion in what they say than the members of the ECB’s Governing Council, which suggests that making process of the FOMC is collegial in that most decisions are unanimous.

Hence, the ECB is more collegial in both its approach to decision-making and in its communication strategy. Ehrmann and Fratzscher (2005) further analyze whether these differences in communication strategies have an impact upon the effectiveness of communication. They find that the predictability of policy decisions is high for the FOMC and the Governing Council. However, the reaction of

US markets to the statements by Chairman Greenspan was significantly stronger than to the statements made by other FOMC members; this differs from the euro area, where the markets respond similarly to communication by the ECB President and other Governing Council members. The two authors conclude that the policies of both the ECB and the Fed are equally effective, despite the fact that they pursue different communication strategies.

2.5 Monetary policy strategies The main elements of the ECB’s monetary policy strategy are a quantitative definition of price stability and a comprehensive analysis of the risks to price stability (Issing et al 2003 and ECB, 2003a). In the pursuit of price stability, the ECB aims to maintain year-on-year increases in the

Harmonized Index of Consumer Prices (HICP) of below, but close to, 2 percent over the medium term. This clarification can be seen as an attempt by the ECB to reduce disinflationary effects to a strict minimum and to keep inflation expectations within a rather narrow margin. As Issing stated in 2003, “this ‘close to 2%’ is not a change, it is a clarification of what we have done so far, what we have achieved – namely inflation expectations remaining in a narrow

range of between roughly 1.7% decisions, and the ability of policymakers to influence financial markets by moving asset prices. The different risks to price stability are assessed by integrating monetary analysis with economic analysis into a unified framework. The economic analysis ─ focusing on the most immediate causes of inflation, such as cost developments and demand-supply imbalances ─ primarily helps to assess short to medium-term

economic developments and consequently risks to price stability over that horizon. The monetary analysis ─ focusing on the ultimate monetary determinants of inflation ─ mainly contains information for assessing price trends at medium to long-term horizons. In this context, the monetary analysis predominantly serves as a means of cross-checking, from a medium to a long-term perspective, the short to medium-term indications stemming from the economic analysis.

ECB officials have on various occasions explicitly referred to the advantages of the ECB’s monetary policy strategy. For instance, it was stated that “the combination of commitment and flexibility that characterises the ECB’s strategy allows for some ‘constrained discretion’ on dealing with cyclical output fluctuations in a way consistent with the preservation of price stability” (Papademos, 2003). Similar statements have also been expressed by

Fed officials: “The approach to monetary policy that I call ‘constrained discretion’ can be defined by two simple and parsimonious principles. First, through its words and (especially) its actions, the central bank must establish a strong commitment to keeping inflation low and stable. Second, subject to the condition that inflation is to be kept low and stable, and to the extent possible given our uncertainties about the structure of the economy and

the effects of monetary policy, monetary policy should strive to limit cyclical swings in resource utilization” (Bernanke, 2003b). These quotes seem to show some similarities in the interpretation of the respective monetary policy strategies. After the stability of money demand broke down in the early 1990s, the Fed started to pursue a multi-indicator approach (Ruckriegel and Seitz, 2002), attaching less importance to monetary aggregates, but utilising a broad range of financial

and economic indicators in assessing its policy stance (Greenspan, 1993). While some commentators have labelled this approach a “just-do-it strategy” (Mishkin, 2003), Fed officials prefer to term it a “stitch-in-time strategy” (Blinder, 1995). 3. Some facts of the economic and financial environment This section compares some features of the economic and financial environment in which the central banks

have been operating over a period starting in the 1980s and ending in 2004. This sample allows us to capture some important developments, although the comparison only has an illustrative purpose, given that the euro area did not start operating until 1999. This entails two important limitations. The first is that, in order to carry out a meaningful analysis, we are forced to use synthetic euro area data for a large part of the sample period, which obviously

restricts our ability to interpret the results. The second limitation stems from the fact that the euro area is indeed a new monetary area, even though the process of European integration started as far back as the 1950s for a smaller subset of European countries. The sharing of a new single currency among a group of countries is deemed to engender “endogenous effects”, i.e. it may contribute to a further deepening of economic and financial integration.

This builds on the seminal contributions of Frankel and Rose (1998) and Rose (2004), who discuss how the euro area could indeed turn into a so-called optimum currency area (OCA), even if this was not the case before. Therefore, the euro area may be witnessing some rapid transformation that the other two areas have already experienced. Looking at developments in the main macroeconomic variables, it is notable that

all the three areas have exhibited declining inflation and falling short-term and long-term interest rates since the early 1980s, a process that only temporarily reversed between 1987 and the early 1990s (for more details on the worldwide shift in the inflation process towards a low inflation environment,see Cecchetti and Debelle, 2006). Since the early 1990s, the process of disinflation has been accompanied by significant fiscal consolidation in the euro area (not shown).

Furthermore, when considering the euro area, the most recent period is also characterized by the disappearance of the nominal exchange rate and, to a large extent, of inflation risk premium; a slowdown in productivity and population growth; and increasing credibility of the convergence process (although at different speeds across national economies). 2 5. Conclusion This paper has analyzed the similarities and the differences among the

Eurosystem and the Fed. It finds that, while several of their tasks and their respective legal statuses differ somewhat, there are fewer differences in their institutional structures and monetary frameworks, as well as the use of instruments. Central banking practices around the world have also evolved in the direction of greater independence, transparency and the adoption of monetary policy committees, among other developments. This has contributed to reducing the differences among the three institutions,

a trend that can also be observed among other central banks. There are, however, some de facto differences in the way monetary policy committees operate. For example, when taking monetary policy decisions, both the Governing Council of the ECB and the Board of Governors of the Fed officially act by simple majority voting. In practice, both the

Governing Council and the FOMC operate as collegial committees. At the same time, FOMC and Governing council differ in terms of legal status which allows different amounts of independence, ECB having more independence, but Fed having more transparent and accountable structure, which allows more open process of decision making. In case of ECB, it has less power in terms of tools available, what is a consequence of environment

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