Full text of Review (Federal Reserve Bank of St. Louis) : January/February 2003, Vol. 85, No. 1

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The Impact of Changes in FOMC Disclosure
Practices on the Transparency of Monetary Policy:
Are Markets and the FOMC Better “Synched”?
William Poole and Robert H. Rasche
ince 1989, the Federal Open Market Committee (FOMC) has adopted many practices that
improve the transparency of its policy actions.
The following list includes some of those practices
and their initiation dates:

• August 1989: Policy changes in the funds rate
target are limited to multiples of 25 basis
points.
• February 1994: A press statement describing
policy actions is released at the conclusion
of any FOMC meeting at which an action was
undertaken.
• August 1997: Public acknowledgment is made
that policy is formulated in terms of a target for
the federal funds rate (the intended funds rate).
• August 1997: A quantitative intended funds
rate is included in the Directive to the Federal
Reserve Bank of New York.
• May 1999: A press statement is issued immediately following the conclusion of every
FOMC meeting at which there are major shifts
in the Committee’s views about prospective
developments. Such statements provide an
indication of the policy “bias.”
• January 2000: A “balance of risks” statement
in the announcement replaces the previous
policy “bias.” After every meeting, the FOMC
issues a statement that reports the settings of
the target funds rate and the balance of risks.
• March 2002: The vote on the Directive and
the names of dissenting members, if any, are
included in the press statement.

vide better information to market participants about
the future direction of policy. This analysis examines
how expectations of market participants about
future policy actions have changed over the decade
during which these changes were implemented.
Our measure of how market participants
respond to “news” is the daily change in the yield
on a one-month-ahead futures contract for federal
funds. The yield on this contract can be interpreted
as a measure of a consensus forecast in the market
of the average effective federal funds rate over the
next calendar month. For example, the change in
the yield on the one-month-ahead federal funds
futures contract from the close of business yesterday
until the close of business today is a measure of the
impact of today’s news in the market. This measure
of news is not unique, but we have found it highly
correlated with measures that other researchers
have proposed, as well as with the commentary on
economic information that appears in the press.1
Small changes in our measure of news reflect
merely ambient noise in financial markets, absent
the revelation of any significant information. From
our examination of the data, we have concluded
that a change in our measure smaller than 5 basis
points in absolute value is insignificant “noise.”2
The behavior of our news measure on days that
the FOMC changed the intended federal funds rate
is shown in Figure 1. This figure is rather complex
because we have attempted to present a large amount
of data.
• The time line starts with October 1988, when
trading began in the federal funds futures
market, and continues through the December
2001 FOMC meeting when the intended federal funds rate was lowered to 1.75 percent.
• The data shown are the daily changes (close
of business to close of business) in the yield

The purpose of these changes, which have gone
a long way toward lifting the traditional veil of
secrecy over monetary policy, is to increase transparency of policy, improve accountability, and proWilliam Poole is the president and Robert H. Rasche is a senior vice
president and director of research at the Federal Reserve Bank of St.
Louis. The views expressed do not necessarily reflect official positions
of the Federal Reserve System.

For additional discussion and analysis of expectations about future
federal funds rates, see Poole and Rasche (2000) and Kuttner (2001).

For a detailed analysis see Poole, Rasche, and Thornton (2002).

J A N UA RY / F E B R UA RY 2 0 0 3

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Poole and Rasche

Figure 1
Surprises to Fed Funds Futures Rate When Policy Actions Were Implemented
Basis Points
30

8/89: All subsequent changes in

→ multiples of 25 basis points.

2/94: All subsequent changes accompanied by

→ press statement at end of FOMC meeting.

10
0
–10
–20
–30

Lt Blue = Intermeeting target changes
Dk Blue = Target changes at scheduled meetings

–40

20
/9
1
/2
0/
9
4/ 1
20
/9
10
2
/2
0/
92
4/
20
/
10 93
/2
0/
9
4/ 3
20
10 /94
/2
0/
9
4/ 4
20
/
10 95
/2
0/
9
4/ 5
20
/
10 96
/2
0/
9
4/ 6
20
/
10 97
/2
0/
9
4/ 7
20
/9
10
8
/2
0/
98
4/
20
/
10 99
/2
0/
9
4/ 9
20
/0
10
0
/2
0/
00
4/
20
10 /01
/2
0/
01

89
0/

–50

NOTE:
25-basis-point change,
50-basis-point change,
75-basis-point change,
immediately aware had occurred (Poole, Rasche, and Thornton, 2002).

•

•
•

on the one-month-ahead federal funds
futures contract.
The points plotted in light blue indicate policy
actions that were undertaken between regularly scheduled FOMC meetings. Points plotted
in dark blue indicate policy actions undertaken at regularly scheduled FOMC meetings.
Points plotted with a square indicate 25-basispoint changes in the intended funds rate;
points plotted with a triangle indicate 50-basispoint changes in the intended funds rate; and
the point plotted with a diamond (November
15, 1994) indicates a 75-basis-point change
in the intended funds rate.
The area shaded in gray, plus and minus 5
basis points, indicates the region that we have
defined as insignificant noise in this market.
The graph is divided into three sections, each
of which reflects a different context in which
FOMC policy actions were implemented.
(i) Before August 1989, policy actions were
not announced and were frequently smaller
than 25 basis points. Our reading of the
news reports indicates that in most cases
market participants were not aware of these
policy actions on the day following the decision. These points are plotted as circles.

J A N UA RY / F E B R UA RY 2 0 0 3

change that market was not

(ii) From August 1989 until February 1994, all
policy actions were 25 basis points or multiples thereof but were not publicly announced.
However, with four exceptions, we were able
to confirm from newspaper reports that market participants detected the policy action
on the day following the decision.
(iii) From February 1994 to the present, all
policy actions were 25 basis points or multiples thereof and each action was publicly
announced by the FOMC following the
decision.
Our conclusion from this analysis is that intermeeting moves (the light blue points) generate news
to the market. That is, such moves generally surprise
markets. In many cases these surprises are large.
The FOMC and market participants are not well
“synched” in these circumstances. In contrast, policy
actions taken at regularly scheduled FOMC meetings,
particularly since February 1994, generate little if
any news in the market. Such actions have been
well anticipated by market participants. The data
suggest that these actions at most involved small
surprises. In these circumstances the FOMC and
market participants seem to be well synched. Our
interpretation is that financial market participants

Poole and Rasche

FEDERAL RESERVE BANK OF ST. LOUIS

Figure 2
Surprises on FOMC Meeting Dates with No Policy Actions
Basis Points
30

2/94: All subsequent changes accompanied by

→ press statement at end of FOMC meeting.
20
2

0
–10

–20
–30

Dk Blue = Absolute changes ≤ 5 basis points
Lt Blue = Absolute changes > 5 basis points

–40

/2
1/
0

1
10

10
/2
1/
0

00
1/
10
/2

/9
21
10
/

98
1/
10
/2

96
1/
/2
10

4
21
/9
10
/

93
1/
/2
10

92
10

1
/9
21
10
/

89
1/
/2
10

–50

NOTE: Surprises before 2/94: (1) = 3/29/89 (–.07), (2) = 8/21/91 (.06), (3) = 12/19/91 (.06), (4) = 10/7/92 (.07);
surprises since 2/94: (5) = 9/27/94 (–.08), (6) = 12/20/94 (–.11), (7) = 9/24/96 (–.13), (8) = 5/20/97 (–.09), (9) = 1/30/02 (.06).

have observed incoming information on the economy and have correctly perceived how the FOMC
will respond to that information.
The second graph, Figure 2, refers to cases where
“the dog didn’t bark”—FOMC meetings at which no
policy action was implemented.
• The time line starts with October 1988, when
trading began in the federal funds futures
market, and continues through the September
2002 FOMC meeting.
• The area shaded in gray, plus and minus 5
basis points, indicates the region that we have
defined as insignificant noise in this market.
• There are only nine points over the entire
period that we believe indicate surprises to
market participants. Four of these occurred
before February 1994 and five occurred subsequent to that date. All of the “surprises” are
relatively small.
The conclusion from this graph is that the FOMC
and market participants have been well synched in
those circumstances when the FOMC believed that
the incoming information on the economy was not
sufficient to justify a policy action.

If market participants are well synched with the
FOMC, then what types of information are providing
the clues about future FOMC policy actions to the
markets? Figure 3 is a case study of the period since
the beginning of December 2000 through May 31,
2002. During this period the FOMC reduced the
intended funds rate from 6.5 percent to 1.75 percent.
• The data plotted are the daily changes in
yield on the one-month-ahead federal funds
futures contract. There are a total of 374
observations.
• The area shaded in gray indicates a range of
plus and minus 5 basis points in which we
interpret the daily changes as merely ambient
noise in the market.
• Fifteen observations (4.0 percent of the total)
are positioned below the zero line in blue.
These represent events where the funds rate
futures contract fell by more than 5 basis
points.
• Ten observations (2.7 percent of the total)
are positioned above the zero line in black.
These represent events where the rate rose
by more than 5 basis points.
J A N UA RY / F E B R UA RY 2 0 0 3

REVIEW

Poole and Rasche

Figure 3
News Affecting Daily Fed Funds Futures Rate
December 1, 2000 – May 31, 2002
Basis Points
15
10

8
10

5
0
–5

–10

4
5

–15

11
–20
–25
–30

–35
–40
7
3/
8/
3/ 01
27
4/ /01
16
/0
5/ 1
3/
5/ 01
22
/0
6/ 1
11
/
6/ 01
28
/0
7/ 1
18
/0
1
8/
6/
8/ 01
23
/0
9/ 1
13
/
10 01
/1
/0
1
10
/1
9/
11 01
/7
11 /01
/2
8/
01
12
/1
7/
01
1/
7/
1/ 02
25
2/ /02
13
/0
3/ 2
5/
0
3/ 2
22
/
4/ 02
11
/
4/ 02
30
/0
5/ 2
17
/0
2

1
/0
1
19

10
1/

0/
/2

–45

NOTE: Numbers above the zero line (in black, 1-10) indicate events where the federal funds futures rate rose by more than
5 basis points. Numbers below the zero line (in blue, 1-15) indicate events where the rate fell by more than 5 basis points.
These numbers correspond to those in Table 1.

• The front page and the Credit Markets column
in the Wall Street Journal have been checked
for news associated with each of the twentyfive labeled events. The reports that appear
there are indicated in Table 1. In four cases
we have not found any “economic news” cited
in either source. Six of the labeled changes
are the FOMC actions noted in Figure 1
(excluding September 17, 2001, where simultaneously there is economic news, the intermeeting policy action, and the reopening of
the equity markets after the terrorist attacks).
Ten of the labeled changes are associated
with the release of economic data, including four involving the release of employment
data. Three of the labeled changes are associated with congressional testimony of
Chairman Greenspan. One labeled change
followed public remarks by other Federal
Reserve officials. The remaining labeled
4

J A N UA RY / F E B R UA RY 2 0 0 3

change is the aftermath of the terrorist
attack and intermeeting policy action of
September 17, 2001.
The conclusions from Figure 3 are that (i) important news arrives relatively infrequently and (ii) the
most significant news is FOMC actions (e.g., April 18,
2001; event 7, below zero line in blue), statements
and testimony by FOMC members (e.g., January 11,
2002; event 15, below zero line in blue), or new
economic data that market participants believe will
affect future FOMC actions (e.g., September 7, 2001;
event 10, below zero line in blue).
If markets are well synched with FOMC policy
actions, then how far in advance are accurate forecasts formed? In some cases the lead-time is considerable. Figure 4 provides a case study using the June
2002 futures contract. In this graph, daily data on
the level of the futures rate are plotted.

Poole and Rasche

FEDERAL RESERVE BANK OF ST. LOUIS

Figure 4
June 2002 Fed Funds Futures Rate

3.50
3.25

FOMC

1
2

→

3.75

FOMC FOMC

→

4.00

3.00
4

→

2.50

→

2.25

7
9

→

1.75

→

2.00

→

2.75

Intended Federal Funds

1.50
1.25
1.00
0.75
0.50

2
/0
22
4/

2/
02
4/

2
/0
20
2/

2
/0
30
1/

01
8/
/1
12

1
/0
/6
11

1
/0
26
9/

0.25

NOTE: Boxed numbers correspond to numbered events in Table 2.

• This contract began trading at the beginning
of September 2001.
• The vertical lines indicate the days of FOMC
meetings and policy actions between meetings.
• The blue line indicates the intended federal
funds rate.
When the June 2002 contract initially traded,
the then-prevailing 3.5 percent intended funds rate
was anticipated to hold over the next ten months.
This conviction eroded substantially upon the
release of the August 2001 advanced retail sales
and employment numbers (see event 1 in Table 2).
Going into the terrorist attacks of 9/11, market participants saw a 3.25 percent intended funds rate in
June 2002.
With the terrorist attacks, market expectations
of the June 2002 intended funds rate were revised
sharply downward to about 2.5 percent, well below
the intended funds rate that prevailed over the

remainder of September 2001 (see event 2 in Table 2).
Expectations gradually eroded by a cumulative 75
basis points from mid-September until shortly after
the November FOMC meeting, during which time
the FOMC reduced the intended funds rate by 100
basis points in two steps.
With the news that the Taliban had left Kabul
and the release of data on October retail sales in midNovember, expectations of the June 2002 intended
funds rate were revised sharply upward to almost
2.5 percent (see event 3 in Table 2). This euphoria
lasted only a few days until the release of data on
new home construction in October (see event 4 in
Table 2) and existing-home sales and consumer
confidence (see event 5 in Table 2). At this time the
then-prevailing intended funds rate of 2.0 percent
was expected to continue until mid-2002.
The release of manufacturing data for November
generated an upward revision of expectations of
J A N UA RY / F E B R UA RY 2 0 0 3

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Poole and Rasche

Table 1
Futures Rate Changes and Reported News Events
Date

Futures
rate change

1/9/2001

0.06

No front-page reports 1/10/2001.

1/12/2001

0.07

“Retail sales inched up 0.1% in December, though downward revisions
for October and November cancelled that slight gain. Core prices rose
0.3%.” WSJ 1/15/2001, p. 1

2/1/2001

0.06

“The jobless rate edged up to 4.2% last month, its highest level since
September 1999 but only a bit above the near 30-year-low of 4% set in
December.” WSJ 2/5/2001, p. 1

2/28/2001

0.07

“Greenspan dashed hopes for an imminent interest-rate cut, pushing
stocks down. The Fed chairman told a House panel that recession
poses a greater risk than inflation as consumer confidence continues
to slide, suggesting that a rate cut is likely at the Fed’s regular March 20
meeting. But he disappointed investors who had hoped for signs of an
earlier reduction.” WSJ 3/1/2001, p. 1

3/23/2001

0.07

No front-page reports 3/26/2001.

4/10/2001

0.08

No front-page reports 4/11-12/2001. “The bond market received a blow
when Fed officials’ remarks pointed to the chances of a recovery of
the U.S. economy sooner rather than later, reducing hopes among some
market participants that future rate cuts will be as aggressive as previously anticipated. William Poole, president of the Federal Reserve Bank
of St. Louis, said that while the U.S. economy has slowed, ‘weaker nearterm prospects seem not to have dimmed the long-run outlook of
robust growth’.” WSJ 4/11/2001, p. C19

4/11/2001

0.06

“In public appearances this week, Fed officials have sounded a generally
upbeat tone on the economy, with some projecting an acceleration
of growth after a weak first half. Analysts said that suggests the Fed
isn’t concerned enough about the economy or other factors to cut
rates immediately.” WSJ 4/12/2001, p. C17

6/27/2001

0.08

“The Fed cut interest rates for the sixth time this year, lowering its federalfunds target by a quarter point to 3.75%. Though the cut was the
smallest this year, the central bank signaled it was poised to keep easing
credit conditions. The Fed move didn’t jar the market, even though
many analysts had predicted a half-point cut.” WSJ 6/28/2001, p. 1

9/4/2001

0.09

“The manufacturing sector appears to have turned a corner in August,
as the NAPMs index of manufacturing activity showed significant
improvement.” WSJ 9/5/2001, p. 1

9/20/2001

0.07

“At a Senate hearing, Greenspan painted a grim picture of short-term
economic weakness, citing weak corporate earnings and layoffs. A
survey of economic forecasters said the economy is heading into a
recession, and that it will last at least through the year.” WSJ 9/21/2001,
p. 1

12/5/2001

0.06

“Manufacturing is showing incipient signs of recovery for the first time
in over a year. Meanwhile, the service sector rebounded last month
after suffering its worst month on record in October.” WSJ 12/6/2001, p. 1

Event

J A N UA RY / F E B R UA RY 2 0 0 3

News reported

Poole and Rasche

FEDERAL RESERVE BANK OF ST. LOUIS

Table 1 cont’d
Futures Rate Changes and Reported News Events
Date

Futures
rate change

1/2/2001

–0.09

“Manufacturing activity slowed last month to its weakest point in almost
10 years, as the NAPM index fell to 43.7 from 47.7 in November.”
WSJ 1/3/2001, p.1

1/3/2001

–0.29

“The Fed cut a key interest rate, sending markets soaring. The central
bank, in a rare move between meetings, lowered the federal funds
target to 6.0% from 6.5%.” WSJ 1/4/2001, p. 1

1/4/2001

–0.19

“Most retail chains reported disappointing December sales, making the
holiday shopping season the worst in at least five years.” WSJ 1/5/2001, p. 1

1/18/2001

–0.06

“Housing starts edged up last month but applications for building permits
fell, suggesting a further slowdown.” WSJ 1/19/2001, p. 1

1/30/2001

–0.06

“Consumer confidence plunged in January, cementing expectations that
the Fed will cut rates by half a point and sparking hopes of an even
bigger cut.” WSJ 1/31/2001, p. 1

2/23/2001

–0.08

No front-page reports 2/26/2001.

3/14/2001

–0.10

No front-page reports 3/15/2001.

3/22/2001

–0.06

“Leading economic indicators fell for the fourth time in five months in
February, but still didn’t point to a recession.” WSJ 3/23/2001, p. 1

4/18/2001

–0.42

“The Fed cut short-term interest rates by a half point in a surprise move
that sent stocks soaring.” WSJ 4/19/2001, p. 1

5/4/2001

–0.07

“Unemployment jumped to 4.5% in April from 4.3% the month before,
raising fears that consumers will curtail spending and spark a recession.”
WSJ 5/7/2001, p. 1

5/15/2001

–0.07

“The Fed cut short-term rates by half a point, its fifth big rate reduction
in as many months, and did nothing to signal that it is ending its
campaign to jump-start the economy.” WSJ 5/16/2001, p. 1

9/7/2001

–0.12

“The surge in unemployment is raising fears that the business cycle may
be entering a new and harrowing phase.” WSJ 9/10/2001, p. 1

9/14-19/2001

–0.41

September 11, 2001, terrorist attack on World Trade Center

10/2/2001

–0.08

“The Fed cut the target for its federal-funds rate to 2.5% from 3% and
left the door open to further rate cuts, as it continued an aggressive
campaign to stimulate the economy.” WSJ 10/3/2001, p. 1

11/6/2001

–0.11

“The Fed cut interest rates by half a point to their lowest level since 1961
and, citing a deteriorating economy, suggested more cuts could be in
store.” WSJ 11/7/2001, p. 1

12/7/2001

–0.07

“A rise in the jobless rate last month to its highest level in over six years
damped predictions that an economic recovery has begun. Economists
expect the Fed to lower rates again tomorrow.” WSJ 12/10/2001, p. 1

1/1/2002

–0.09

“Greenspan said the economy shows signs of stabilizing but still faces
major risks before a sustainable recovery can begin. The downbeat
assessment raises the odds the Fed again will cut interest rates at its
meeting this month.” WSJ 1/14/2002, p. 1

Event
1

News reported

NOTE: The first 10 numbers (corresponding to the upper numbers in Figure 3, in black) indicate events where the funds rate futures
contract rose by more than 5 basis points. The next 15 numbers (corresponding to the lower numbers in Figure 3, in blue) indicate
events where the rate fell by more than 5 basis points.

J A N UA RY / F E B R UA RY 2 0 0 3

REVIEW

Poole and Rasche

Table 2
Futures Rate Changes and Reported News Events
Date

Futures
rate change

9/6/2001

–0.15

“Discount stores performed well in August, but specialty-apparel retailers
and high-end department stores suffered.” WSJ 9/7/2001, p. 1

9/7/2001

–0.20

“The surge in unemployment is raising fears that the business cycle may
be entering a new and harrowing phase.” WSJ 9/10/2001, p. 1

9/13/2001

–0.63

September 11, 2001, terrorist attack on World Trade Center

11/13/2001

0.06

“Rebels Seize Kabul As Taliban Forces Flee Afghan Capital” WSJ 11/14/2001,
p. 1

11/14/2001

0.16

“Retail sales shot up a record 7.1% in October. The surge was led by a
26.4% jump in auto sales, which were aided by zero-percent financing
and other incentives.” WSJ 11/15/2001, p. 1

Event
1

News reported

11/15/2001

0.21

—

11/16/2001

0.13

“Consumer prices slipped in October amid continued drops in energy
prices, a possible positive sign for reigniting spending. But industrial
output fell for the 13th straight month, the longest string of declines
since the Depression.”
“Hiring plans are approaching a weakness not seen since the
recessionary early months of 1991—Manpower’s survey of nearly 16,000
companies says.” WSJ 11/19/2001, p. 1

11/19/2001

–0.15

“New-home construction fell 1.3% in October and builders requested
permits at the slowest pace in four years, another sign that the housing
market is slowing.” WSJ 11/20/2001, p.1

11/27/2001

–0.25

“Existing-home sales rose 5.5% last month after a weak September. But
consumer confidence, hurt by layoffs, slid in November to an eightyear low.” WSJ 11/28/2001, p. 1

12/5/2001

0.16

12/7/2001

–0.14

1/11/2002

–0.19

3/7/2002

0.07

“Greenspan gave the Senate a considerably more upbeat assessment of
the economy than he did in House testimony last week. The Fed
chairman said recent evidence suggests ‘an economic expansion is
already well under way’.” WSJ 3/8/2002, p. 1

3/26/2002

–0.06

“Consumer confidence surged in March to its highest level since before
the Sept. 11 attacks, suggesting the U.S. may enjoy a broad economic
recovery.” WSJ 3/27/2002, p.1

J A N UA RY / F E B R UA RY 2 0 0 3

FEDERAL RESERVE BANK OF ST. LOUIS

Poole and Rasche

the June 2002 intended funds rate (see event 6 in
Table 2), but this expectation was reversed when
November employment data became available two
days later (see event 7 in Table 2).
From the December 2001 FOMC meeting until
the end of May 2002, the June 2002 contract traded
in the range of 1.75 to 2.0 percent, with the exception of a couple of days in January. The yield briefly
dropped below 1.75 percent after the January 11,
2002, Congressional testimony of Chairman
Greenspan, which was widely interpreted as pessimistic and as a signal that an additional cut in the
intended funds rate might be forthcoming (see event
8 in Table 2). This effect was quite short-lived, and
within a few days the yield was back within the 1.75
to 2.0 percent range. After the Chairman’s Senate
testimony on March 7, 2002, the yield moved to 2.0
percent, indicating a conviction that no later than
the May 2002 FOMC meeting the intended funds
rate would be raised by 25 basis points (see event 9
in Table 2). Between the March FOMC meeting and
mid-April, this conviction gradually eroded, and
for the month prior to the May FOMC meeting a
firmly held conviction prevailed in the market that
no change in the intended funds rate would occur
before the June FOMC meeting.
We conclude, from the small average size of
market surprises concerning FOMC policy changes,
that in recent years the market has had an excellent
understanding of what the FOMC is doing. For the
most part, rate changes occur in response to news
that should change rates. These findings, we believe,
provide strong evidence of the payoff from greater
Fed transparency and greater regularity in monetary
policy actions.

REFERENCES
Kuttner, Kenneth N. “Monetary Policy Surprises and Interest
Rates: Evidence from the Fed Funds Futures Market.”
Journal of Monetary Economics, June 2001, 47(3), pp.
523-44.
Poole, William and Rasche, Robert H. “Perfecting the Market’s
Knowledge of Monetary Policy.” Journal of Financial
Services Research, December 2000, 18(2-3), pp. 255-98.
___________; ___________ and Thornton, Daniel L. “Market
Anticipations of Monetary Policy Actions.” Federal Reserve
Bank of St. Louis Review, July/August 2002, 84(4), pp. 65-94.

J A N UA RY / F E B R UA RY 2 0 0 3

Poole and Rasche

J A N UA RY / F E B R UA RY 2 0 0 3

REVIEW

A Look Inside Two Central Banks:
The European Central Bank and the
Federal Reserve
Patricia S. Pollard

entral banks have existed since the Swedish
Riksbank began operation in 1668. The
Federal Reserve, which was created in 1913,
is thus a relative newcomer in the history of central
banking: At the time of its creation, however, only 20
other central banks existed. The number of central
banks rose rapidly in the post-World War II period
primarily as a result of decolonization. This number
expanded again in the early 1990s as the collapse of
the Soviet Union led to the establishment of central
banks by the former Soviet republics. By 1997 there
were 172 central banks.1 In 1998 the coterie of
central banks expanded by one, when the European
Central Bank (ECB) became the newest member.
Central banking has changed greatly since its
early history, when the primary function of a central
bank was to act as the government’s banker. Broz
(1998) argues that financing military endeavors was
the main reason for the establishment of the early
central banks, pointing out that all “central banks
in existence before 1850 were chartered in the
context of war.”2
By the time the Federal Reserve was established,
the role of the central bank had evolved to focus
primarily on providing stability in banking and
financial systems. At this point, no mention had
been made of monetary policy. The Federal Open
Market Committee (FOMC), the policymaking group
of the Federal Reserve, was not created until 1933.3

Today the primary function of a central bank
is, in fact, monetary policy. Moreover, it is widely
accepted that a central bank needs to be able to
operate independently within the government to
best achieve its monetary policy goals. The statutes
governing the ECB reflect these shifts and establish
monetary policy as the primary function of the ECB,
with many other tasks being delegated to the national
central banks. The 1993 Maastricht Treaty amendments to the Treaty Establishing the European
Community required that not only the ECB, but
also the national central banks, be independent. In
the 10 years since the Maastricht Treaty was signed,
increasing attention has focused on counterbalancing central bank independence with accountability
and transparency.
This article examines modern central banking
with a focus on the world’s two most prominent
central banks—the Federal Reserve System and the
European Central Bank.4 First, it examines the structure and appointment process of the key policymakers at the central banks. Next, it highlights the
tasks of the central banks, focusing on the monetary
policy process. The goals and tools of monetary
policy as well as the decisionmaking process and
how they differ in each system are discussed. Finally,
the article examines accountability and transparency
in the Federal Reserve and the ECB.

See Pringle (2002).

STRUCTURE OF THE ECB AND THE
FEDERAL RESERVE

Broz (1998, p. 239).

In 1923 the Federal Reserve Banks of Boston, Chicago, Cleveland,
New York, and Philadelphia established an Open Market Investment
Committee to coordinate open market operations conducted by these
Reserve Banks. In 1930 this was replaced by the Open Market Policy
Conference consisting of the heads of all 12 regional Banks and the
members of the Board of Governors. It was not until the 1935 amendment to the Federal Reserve Act that the regional Banks were prohibited
from conducting independent open market operations. See Meulendyke
(1998) for more details.

On June 1, 1998, the Executive Board of the ECB
held its first meeting at its headquarters in Frankfurt,
Germany. Six months later the ECB assumed responsibility for monetary policy in the euro area, bringing
to fruition a plan for monetary union first outlined
nearly two decades earlier.5
4

The United States and the euro area account for 37 percent of world
output (International Monetary Fund, 2002, Statistical Appendix
Table A).

See the boxed insert “The Path to Monetary Union.”

Patricia S. Pollard is a research officer at the Federal Reserve Bank of
St. Louis. Heidi Beyer provided research assistance.

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THE PATH TO MONETARY UNION
In March 1957, six countries—Belgium, France,
Germany, Italy, Luxembourg, and the Netherlands—
signed the Treaty of Rome, creating the European
Economic Community. The main focus of the
treaty was the creation of a customs union among
the member countries.1 Coordination of monetary
and fiscal policies was mentioned by the Treaty
as important to the well-functioning of a customs
union. The coordination of general economic
policies took place through meetings of the Council
of Economics and Finance Ministers. In 1964
the Committee of Central Bank Governors was
established to coordinate monetary polices in
the member states. This was primarily a forum
for exchanging information.
In the late 1960s economic and monetary
coordination received greater focus, partly in
response to the success of the customs union and
partly in response to the emerging turbulence in
the Bretton Woods fixed exchange rate system.2
In 1970 the Council of the European Communities
established a committee to discuss economic and
monetary union. The group, led by Pierre Werner,
the Prime Minister of Luxembourg, issued a report
advocating a three-stage movement to economic
and monetary union by the end of the decade.
Although the Council initially supported the plan,
the economic instability resulting from the collapse
of the Bretton Woods system and the oil crisis in
the early 1970s led to its demise. It was not until
1988 that another committee was established to
address the issue of monetary and economic
union, this time led by Jacques Delors, the head
of the European Commission.
During the 18-year interval, many changes
had occurred. The European Community went
through three expansions, incorporating six new
members.3 In 1979 the European Monetary System
(EMS) created a fixed exchange rate system in
which all member currencies, except the pound
sterling, participated. Despite frequent adjustments
to the exchange rates in the early years, the success
1

A customs union is characterized by free trade among the member
countries in conjunction with a common external tariff and common
trade policy toward nonmember countries.

For a more detailed discussion of the historical development of
monetary union in Europe, see Arestis, McCauley, and Sawyer (1999).

Denmark, Ireland, and the United Kingdom joined in 1973; Greece
in 1981; and Portugal and Spain in 1986.

J A N UA RY / F E B R UA RY 2 0 0 3

of the EMS in reducing exchange rate variability
and the willingness of countries to adopt the
economic policies necessary to stabilize exchange
rates led to a renewed commitment toward economic and monetary integration. Economic integration was furthered by the passage of the Single
European Act in 1987, which called for the creation
of a free market in the movement of goods, services, and capital by 1993. The creation of a single
European market, it was argued, would be hampered by fluctuations in exchange rates as well
as the costs of exchanging currencies.
In April 1989 the Delors committee released
its report. Like the Werner report, it called for a
three-stage process to achieve economic and
monetary union within a decade.4 The culmination
of the process would be the creation of a supranational institution to set monetary policy and a
single currency.
In December 1991, the European Council
finalized an agreement on changes to the Treaty
of Rome to attain economic and monetary union.5
The amendments (often referred to as the
Maastricht Treaty, after the Dutch town where
the agreement was reached) came into effect in
November 1993 following ratification by the
member states.6
In January 1995, Austria, Finland, and Sweden
entered the European Union, bringing the membership to 15. In May 1998, 11 countries (Austria,
Belgium, Finland, France, Germany, Ireland, Italy,
Luxembourg, the Netherlands, Portugal, and Spain)
were certified as having met the membership
criteria for admission to monetary union and
became members effective January 1, 1999.7
Greece met the membership criteria in 2000 and
became the 12th member in January 2001.
4

The Werner report called for greater integration of fiscal policies
than did the Delors report. The former envisioned the transfer of
national budgetary powers to the European Community (see Wellnik,
1997).

The United Kingdom supported the changes only after it was given
the right to opt out of monetary union.

Denmark rejected the Maastricht Treaty in a referendum. A second
referendum passed after Denmark was also given the right to opt
out of monetary union.

Denmark and the United Kingdom exercised their rights to opt out
of monetary union. Sweden guaranteed its lack of fitness for membership by failing to join the exchange rate mechanism of the
European Monetary System. For a discussion of the membership
criteria for monetary union, see Pollard (1995).

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FEDERAL RESERVE BANK OF ST. LOUIS

Figure 1
The Federal Reserve System

9
12
San Francisco

Boston

Minneapolis

7
10

Cleveland

Chicago

Kansas City

St.Louis

New York
Philadelphia
Board of
Governors
Richmond

8
6
Atlanta

Dallas

Alaska and Hawaii are part
of the San Francisco District

The euro area is unique among commoncurrency areas. Twelve sovereign nations have not
only adopted a common currency, the euro, but have
also created a supranational organization, the ECB;
this institution, along with input from the head of
each member country’s national central bank, sets
monetary policy for the euro area.
Ninety years ago, the Federal Reserve Act created
a central bank for the United States consisting of 12
regional (District) Federal Reserve Banks (Figure 1)
and a seven-member Federal Reserve Board in
Washington, D.C.6 In 1935 the Federal Reserve
Board was renamed the Board of Governors of the
Federal Reserve System.
The European System of Central Banks consists
of 15 national central banks (Figure 2) and a sixmember Executive Board in Frankfurt, Germany.
The 15 central banks correspond to the 15 member
countries of the European Union. The three central
banks whose countries are not members of the
6

The Federal Reserve Act specified that there be “not less than eight
nor more than twelve” Districts (Section 2.1); the text appears at
<fedweb.frb.gov/fedweb/board/legal/lawlib/law-fra.htm>.

euro area participate in few of the activities of the
European System of Central Banks. The Eurosystem
is the term used to refer to the ECB and the 12
national central banks of the member countries.7
The 12 Districts of the Federal Reserve System,
in contrast to the national central banks of the Eurosystem, do not correspond to political entities. These
12 Districts are divided along county lines, encompassing not only multiple states, but portions of
states. Indeed, in the early years of the Federal
Reserve System, some border counties petitioned
and were allowed to switch Districts.8

Appointments to the Board of
Governors and Executive Board
The members of the Board of Governors of the
Federal Reserve System are nominated by the
7

These countries are Austria, Belgium, Finland, France, Germany, Greece,
Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain.
Denmark, Sweden, and the United Kingdom are the three nonmembers.

See Federal Reserve Bank of Minneapolis (1988), Hammes (2001),
and Primm (1989) for more details on the creation of the 12 Districts.

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Figure 2
European System of Central Banks

Sweden
Finland

Denmark
Netherlands
Ireland

U.K.
Germany
Belgium
Luxembourg

ECB
Austria

France
Portugal

Italy
Spain

Greece
NOTE: Only the central banks of the blue shaded countries
are members of the Eurosystem.

President of the United States and must be confirmed
by the U.S. Senate. The chairman and vice chairman
are appointed by the President and confirmed by
the Senate from among the members of the Board,
although appointment to these roles may be simultaneous with appointment to the Board.
In Europe the governments of all the member
states of the euro area must agree on the appointments to the Executive Board. The process begins
with a recommendation by the Council of Economics
and Finance Ministers (ECOFIN).9 Since ECOFIN
comprises the finance ministers of the member
countries of the European Union, its recommendations will reflect the consensus of the member
governments. Once ECOFIN makes its recommendation, the European Parliament and the Governing

Council of the ECB are consulted.10 Following these
consultations the appointments are confirmed by
the heads of state or government of the euro area
members.
The Federal Reserve Act and the Maastricht
Treaty both briefly mention qualifications for membership on the respective boards. The Federal Reserve
Act specifies that
In selecting the members of the Board, not
more than one of whom shall be selected
from any one Federal Reserve district, the
President shall have due regard to a fair
representation of the financial, agricultural,
industrial, and commercial interests, and
geographical divisions of the country.
(Section 10.1)
10

See the boxed insert “Institutions of the European Union.”

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The Governing Council consists of the members of the Executive
Board and the heads of the 12 central banks in the euro area.

FEDERAL RESERVE BANK OF ST. LOUIS

INSTITUTIONS OF THE EUROPEAN
UNION1
Four institutions of the European Union are
mentioned throughout the text. They are the
European Commission, the Council of the European
Union, the European Council, and the European
Parliament.
The European Commission is the executive
branch of the European Union government. The
president of the Commission is nominated by the
European Council and approved by the European
Parliament. The European Council in consultation
with the President of the Commission chooses the
other 19 commissioners. The European Parliament
must reject or accept the proposed Commission,
but may not reject individual members. The
appointments to the 20-member commission are
based on nationalities. France, Germany, Italy,
Spain, and the United Kingdom each are allocated
two commissioners with the remaining ten EU
countries each allowed one appointment.2 All
commissioners serve a five-year renewable term.
The Commission has four main roles: (i) initiate
policies by proposing legislation to the Council
and European Parliament; (ii) administer and
implement European Union policies; (iii) enforce
European Union laws; and (iv) represent the
European Union internationally, particularly in
negotiations regarding trade and cooperation.
During their term in office the commissioners
are expected to represent the interests of the
European Union and not those of their home
1

Information in this section comes from European Communities
(1995-2002) and European Parliament (2001).

Under the Treaty of Amsterdam the number of commissioners
from any member country will be limited to one, at most, as the
European Union expands eastward.

The treaty establishing the ECB set no such requirement for regional or national diversity, simply stating
that “only nationals of Member States may be members of the Executive Board” (Article 112).11 The
treaty did set further qualifications for the Board
members, stating that they must be “persons of
recognized standing and professional experience
in monetary or banking matters” (Article 112).
11

The articles listed in the text refer to the Treaty Establishing the
European Community as amended by the Treaty of Amsterdam in 1997.

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countries. In contrast, the Council of the European
Union (usually referred to as the Council) represents the national governments. The composition
of the Council changes depending upon the issue
being considered. For example, the agricultural
ministers of the member states address issues
related to the Common Agricultural Policy. The
Council of Economics and Finance Ministers
coordinates the economic policies of the member
states.
The Council is the main decisionmaking body
of the European Union. Each country is allocated
a number of votes based loosely on the size of its
population. The Council enacts European Union
laws stemming from proposals submitted by the
Commission. Most decisions are made by a qualified majority vote, which requires 62 of 87 votes
or in some cases 62 votes from at least ten member
countries. Some policies such as tax measures
and foreign policy require unanimity.
The European Council consists of the heads
of state or government of the 15 member countries
and the president of the European Commission
(as a non-voting member). It is not legally an institution of the European Union but plays a key role.
The presidency of the European Council rotates
among the member states on a six-month basis.
The European Council meets at least twice per year
(in June and December). Decisions are generally
reached through consensus.
The European Parliament is the other legislative institution of the European Union. Its 626
members are directly elected for five-year terms.
Although elected nationally, the members of
Parliament are grouped according to party affiliation and not nationality. Although the Parliament
shares some legislative powers with the Council,
its main purpose is to exercise democratic control
over European Union institutions.
In practice, the regional restriction placed by the
Federal Reserve Act is loosely applied. For example,
the two most recently appointed members, Ben
Bernanke and Donald Kohn, represent the Atlanta
and Kansas City Districts, respectively. Neither lived
nor worked in these Districts at the time of his
appointment. What then is the link with the Districts
they represent? Bernanke was born in Georgia and
Kohn worked at the Federal Reserve Bank of Kansas
City in the early 1970s.
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The appointments to the Executive Board of
the Eurosystem, however, have thus far been made
to ensure national diversity. Indeed, given that there
are only half as many positions on this Board as
there are current euro area member countries and
that the ratio will decline as more countries achieve
membership, it is unlikely that there will ever be two
Board members appointed from the same country.
Currently, all the members of the Executive
Board are experienced central bankers, each having
served on the staff of his or her national central
bank.12 Despite the requirement that the members
of the Fed’s Board of Governors should reflect a
range of interests, in recent years they have been
primarily economists and/or bankers.13
Term of Office. Members of the Board of
Governors are appointed for a 14-year term, nearly
twice as long as the eight-year term for members
of the Executive Board. Both are nonrenewable.
The actual term for a member of the Board of
Governors could, however, be much longer: If a
member resigns prior to the end of the term of
office, the new member is appointed to serve the
remainder of the term and then can be appointed
to a full 14-year term.14 Alan Greenspan, for example, was appointed in 1987 to fill the remaining
years of Paul Volcker’s term and was reappointed
in 1992 to a 14-year term.
The chairman and vice chairman of the Board
of Governors serve four-year terms that may be
renewed as long as their terms on the Board have
not expired. Renewal requires nomination by the
President of the United States and the consent of the
U.S. Senate. On the Executive Board, the president
and vice president are appointed for the full eightyear nonrenewable term.
The terms of members on both Boards are staggered to provide continuity.15 In the United States,
however, few members now serve the full 14 years
and the appointment process is sometimes slow,
so multiple vacancies may occur. All members of
the current Board of Governors, with the exception
12

Brief biographies of the members of the Executive Board are available
at <www.ecb.int/about/ab1mem.htm>.

Brief biographies of the members of the Board of Governors are
available at <www.federalreserve.gov/bios>.

of the Chairman, were appointed within the last five
years, and four members were appointed in the last
two years. Figures 3 and 4 show the current members of the Board of Governors and the Executive
Board, respectively, along with the District or country
they represent and the expiration date of their terms.

Appointments of the District Bank
Presidents and the Governors of the
National Central Banks
The president of a Federal Reserve Bank is
appointed by the board of directors of that Bank,
subject to the approval of the Board of Governors.
The term of office of all the presidents expires on
the same date, the last day of February in years ending with a 1 or 6. The president may be reappointed
for an indefinite number of five-year terms, subject
to the following restrictions: mandatory retirement
at age 65 if appointed at or before age 55 or mandatory retirement at age 70 or a 10-year term (whichever comes first) if appointed after age 55.16 There
is no requirement that the president be a resident
of the District prior to appointment.
The appointment of the governor of each
national central bank in the euro area is determined by the respective national government. The
Maastricht Treaty requires that the term of office
be a minimum of five years. The term varies across
countries from five to eight years.17 Eight of the 12
countries allow for a renewable term. The Executive
Board need not be consulted and has no veto power
over these appointments.

Tasks of the Central Banks
Apart from conducting monetary policy, central
banks have a variety of other tasks. These other
duties are often related to the monetary policy function. In general the duties of the Federal Reserve
and the Eurosystem (listed in Table 1) are similar,
yet there are some key differences.18
Both central banks are the sole issuer of banknotes for their respective economies. In the euro
area, production and distribution is controlled by
16

No such age restriction applies to members of the Board of Governors.
Alan Greenspan, for example, will be 78 when his current term as
Chairman expires in 2004.

Since the 1935 amendment to the Federal Reserve Act restricted
future appointees to the Board of Governors to one full term, the
longest anyone has served is 21 years.

The term is five years in Austria, Belgium, Italy, and Portugal; six years
in France, Greece, Luxembourg, and Spain; seven years in Finland,
Ireland, and the Netherlands; and eight years in Germany.

To achieve this in the ECB, the terms of office were set at two to eight
years for the initial Executive Board members.

See Board of Governors (1994) for a more detailed description of the
tasks of the Federal Reserve System.

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FEDERAL RESERVE BANK OF ST. LOUIS

Figure 3
Members of the Board of Governors
Chairman
Alan Greenspan
New York
(January 31, 2006)

Vice Chairman
Roger Ferguson
Boston
(January 31, 2014)

Member
Edward Gramlich
Richmond
(January 31, 2008)

Member
Mark Olson
Minneapolis
(January 31, 2010)

Member
Susan Bies
Chicago
(January 31, 2012)

Member
Ben Bernanke
Atlanta
(January 31, 2004)

Member
Donald Kohn
Kansas City
(January 31, 2016)

NOTE: Date indicates expiration of term.

Figure 4
Members of the Executive Board
President
Willem Duisenberg
Netherlands
(May 31, 2006)

Vice President
Lucas Papademos
Greece
(May 31, 2010)

Member
Sirkka Hämäläinen
Finland
(May 31, 2003)

Member
Eugenio Domingo Solans
Spain
(May 31, 2004)

Member
Tommaso Padoa-Schioppa
Italy
(May 31, 2005)

Member
Ottmar Issing
Germany
(May 31, 2006)

NOTE: Date indicates expiration of term.

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Table 1
Tasks of the Federal Reserve System and European System of Central Banks
FRS

ESCB

Define and implement monetary policy

Yes

Issue banknotes

Yes

Conduct foreign exchange operations

Yes

Hold and manage official reserves

Yes

Act as the fiscal agent for the government

Yes

NCBS

Promote stability of financial system

Yes

Supervise and regulate banks

Yes

Some NCBS

Implement consumer protection laws

Yes

Some NCBS

Promote the smooth operation of the payments system

Yes

Collect statistical information

Yes

Participate in international monetary institutions

Yes

NOTE: NCBS refers to national central banks of the Eurosystem.

the ECB with production occurring in all 12 member
countries. In the United States, Federal Reserve notes
are produced by the Bureau of Engraving and Printing
(part of the U.S. Treasury Department) under the
direction of the Board of Governors. Federal Reserve
notes are then purchased at cost, not face value,
by the Federal Reserve Banks. Production takes place
in only two locations—Fort Worth, Texas, and
Washington, D.C.
Neither the ECB nor the Federal Reserve is
responsible for exchange rate policy (for example,
deciding whether to enter into a fixed exchange rate
arrangement). This responsibility lies with ECOFIN
in the euro area and the Treasury Department in the
United States. ECOFIN is required, however, to consult the ECB before entering into any exchange rate
arrangements and must not allow such arrangements
to take precedence over the ECB’s price stability
objective (Article 111). Both central banks, however,
may intervene in foreign exchange markets and
may hold and manage foreign currency reserves.
Both central banks provide financial services to
the government. These tasks are primarily handled
by one of the Reserve Banks in the United States,
currently the Federal Reserve Bank of St. Louis. In
the euro area each national central bank serves as
fiscal agent for its own government. There are limitations placed on the fiscal agency function of both
central banks to prevent the government from using
this relationship to finance budget deficits. For example, both the Federal Reserve and the European
18

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System of Central Banks are prohibited from extending loans to the government or from directly purchasing securities from the government.
Because of the key role the financial system
plays in the economy, maintaining the stability of
the financial system is an important objective of
both central banks. The Federal Reserve plays a role
in supervising and regulating banks to this end. It
shares supervisory tasks with three federal agencies
and with state agencies. In addition the Federal
Reserve shares tasks with foreign agencies in supervising U.S. banks with branches abroad and foreign
bank branches in the United States.
The Federal Reserve serves as a bank regulator
in setting standards regarding the operations and
activities of banks. As a complement to this regulation, the Federal Reserve implements consumer
protection laws in the area of credit and financial
transactions.
The European System of Central Banks has no
direct role in banking supervision. The Maastricht
Treaty simply states that it
shall contribute to the smooth conduct of
policies pursued by the competent authorities relating to the prudential supervision
of credit institutions. (Article 105)
Responsibility for supervision in the euro area is
determined nationally. Although most national
central banks have some role in supervision, several

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FEDERAL RESERVE BANK OF ST. LOUIS

countries have followed or are considering following
the lead of the United Kingdom in removing supervision from the functions of the central bank. The
ECB has argued for expanding the supervisory role
of the national central banks, as well as increasing
cooperation among those banks (ECB, 2001b).19 In
April 2001 the European System of Central Banks
reached an agreement with the banking supervisory
authorities in the European Union countries to
increase cooperation.20
An important task related to supervision is the
role of the central bank as a lender of last resort.
The Federal Reserve can use the discount window
(discussed here later) to make loans to banks that
are, although solvent, temporarily illiquid. The
Maastricht Treaty does not mention a lender of last
resort function for the ECB, and the ECB has been
criticized for lacking this function.21 Perhaps as a
result of this criticism, although it remains silent
about the specifics, the ECB has reiterated that it has
the ability and the willingness to handle a liquidity
crisis in the euro area banking system. Willem
Duisenberg, president of the ECB, said the following
in response to a question regarding the role of the
ECB as a lender of last resort: “The Governing Council
has this issue well under control but will never make
anything public in this regard” (Duisenberg, 1998).
Tommaso Padoa-Schioppa, a member of the Executive Board, stated that
To the extent that there would be an overall
liquidity effect that is relevant for monetary
policy or a financial stability implication for
the euro area, the Eurosystem itself would be
actively involved. (Padoa-Schioppa, 1999)
Financial regulation and consumer protection
in credit and financial matters generally remains at
the national level in the Eurosystem, although the
European Union is looking at ways to establish regulations both to promote financial integration and
handle the regulatory complications resulting from
such integration.
The role of the central bank in overseeing the
payments system is linked to both its role in ensuring the stability of the financial system and its conduct of monetary policy. The Protocol on the Statute
19

This document provides an overview of the debate regarding the role
of central banks in banking supervision.

See ECB (2001a).

See, for example, Bordo and Jonung (1999) and Prati and Schinasi (1998).

of the European System of Central Banks and of the
European Central Bank permits the ECB and the
national central banks operational roles in the payments system and gives the ECB the authority to
make regulations to “ensure efficient and sound
clearing and payment systems” (Article 22). National
central banks also provide oversight for payment
and clearing systems operated by private entities.
In preparation for monetary union, domestic payments systems were required to meet minimum
standards. The ECB operates TARGET, a real-time
gross settlement system to aid in central bank operations and the settlement of cross-border and largevalue euro payments in the euro area.22 The Federal
Reserve both operates clearing and payments systems and oversees those operated by private entities.
Both central banks cooperate internationally,
generally through the Bank for International Settlements, in working to minimize the risk of problems
arising in cross-border payments. International
cooperation extends to other areas of central banking, particularly in issues related to financial stability
and monetary policy. Central bankers from the ECB
and the Federal Reserve participate in meetings of
the international monetary institutions as well as
less formal forums for discussion.
Both central banks collect and publish data
related to banking and monetary aggregates, as well
as other indicators of economic activity. These data
are particularly useful in the central banks’ task of
implementing monetary policy. Interestingly, neither
central bank collects the data used to measure inflation. These data are constructed by the Bureau of
Labor Statistics in the United States and Eurostat in
the European Union.

MONETARY POLICY
The main function of both the Federal Reserve
and the ECB is to conduct monetary policy to
achieve the goals assigned by their respective charters. This section begins with a discussion of these
goals, followed by an analysis of the tools available
to the two central banks in conducting monetary
policy. It then turns to the monetary policy decision process, looking at both the differences in the
decisionmaking bodies in the United States and the
euro area and the process by which decisions are
made.
22

For more details on payment and clearing systems in the euro area,
see ECB (2001b).

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Figure 5

Table 2

Federal Funds Target and Effective Rate

Tools of Monetary Policy

January 1, 1999, to September 20, 2002
Percent
7.0

Federal Reserve

ECB

Open market operations

6.5

Discount window

Standing facilities

6.0

Reserve requirements

5.5
5.0
4.5
4.0
3.5
3.0
2.5

Federal Funds Rate

2.0

Federal Funds Rate Target

1.5
1.0
Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul
99 99 99 99 00 00 00 00 01 01 01 01 02 02 02

Monetary Policy Goals
The primary goal of the Eurosystem as set forth
by the Maastricht Treaty is to “maintain price stability” (Article 105.1). The treaty further instructs the
Eurosystem to “support the general economic
policies” (Article 105.1) in the euro area without
prejudice to the goal of price stability. Thus, the
treaty makes it clear that any other objectives are
secondary to that of price stability.
The ECB has given a quantitative definition to
its mandate of price stability. Price stability is “a
year-on-year increase in consumer prices of below
2%” (ECB, 2001c) as measured by the monetary
union index of consumer prices for the euro area.23
Because prices are affected in the short-run by many
factors outside the control of the central bank and
because monetary policy actions take time to affect
inflation, the objective is seen as applying over the
medium term.
The Federal Reserve System has three policy
goals: “maximum employment, stable prices and
23

The monetary union index of consumer prices is a weighted average of
the harmonized indexes of consumer prices for the euro area countries.
The weights are based on each country’s share of euro area private
domestic consumption expenditures. The harmonized indexes of
consumer prices cover the same set of goods and services in each
country and are calculated using the same methodology. The weights
given to each item within the index, however, vary across countries
based on the expenditure habits of the country’s consumers.

J A N UA RY / F E B R UA RY 2 0 0 3

moderate long-term interest rates” (Section 2A).24
Unlike the Eurosystem’s mandate, price stability is
not given a higher priority than the other goals.
Clearly, the policymakers of the Federal Reserve
must assign at least an implicit ranking to these
goals; in the long-run all three goals are compatible,
but this is not necessarily true at every point in time.
Perhaps as a result of this incompatibility, the Federal
Reserve has never defined any of the goals.25 Alan
Greenspan has given what he termed “an operating
definition of price stability”: “Price stability obtains
when economic agents no longer take account of
the prospective change in the general price level in
their economic decisionmaking” (Greenspan 1996).

Monetary Policy Tools
The tools available to the two central banks are
listed in Table 2.26 In its policy meetings, the Federal
Reserve sets a target for the federal funds rate, the
interest rate banks charge each other to borrow
reserves overnight. The Federal Reserve does not
directly determine this interest rate but can control
it through open market operations, which directly
affect bank reserves. The Federal Reserve conducts
24

The 1913 Federal Reserve Act did not contain any macroeconomic
goals. The 1946 Employment Act required the federal government to
“promote maximum employment, production and purchasing power.”
Although the act did not mention the Federal Reserve, it was interpreted
as applying to it. The 1977 Federal Reserve Reform Act specified the
three goals listed in the text. See Judd and Rudebusch (1999) for a
discussion of the goals of U.S. monetary policy.

The 1978 Full Employment and Balanced Growth Act (commonly
known as the Humphrey-Hawkins Act) specified goals of 3 percent for
inflation and 4 percent for unemployment to be reached by 1983. The
President was required to report in the Economic Report of the President
the progress in meeting these goals. If the goals could not be met, the
President was required to set revised goals. The Federal Reserve was
required to report to Congress twice per year on its own objectives and
how these related to the administration’s goals. In practice, the Federal
Reserve compared its forecasts for growth, unemployment, and inflation over the next two years with those of the administration.

See Board of Governors (1994, Chap. 3) and ECB (2002) for a more
detailed description of the monetary policy tools.

Pollard

FEDERAL RESERVE BANK OF ST. LOUIS

open market operations by buying or selling U.S.
government securities (typically Treasury bills).
Generally, open market operations are conducted
as repurchase agreements. For example, the Federal
Reserve sells securities with an agreement to repurchase them at a later date, usually no more than
seven days later. The open market desk at the Federal
Reserve Bank of New York is active daily in the
market. As Figure 5 shows, through open market
operations the Federal Reserve manages to keep
the federal funds rate close to its target rate.27
Open market operations conducted by the ECB
are similar in some respects to those of the Federal
Reserve. The ECB’s most common open market
operations, that is, main refinancing operations,
are repurchase agreements that have a maturity of
two weeks. There are, however, a few key differences
between the use of open market operations by the
Federal Reserve and the ECB. The ECB conducts
main refinancing operations only once per week in
contrast to the Fed’s daily operations. Secondly, the
Federal Reserve deals exclusively in U.S. government
securities, whereas the ECB has a broader range of
assets (even beyond that of securities issued by
member country governments) that it accepts.
Another difference is that, in the euro area, open
market operations are decentralized; each national
central bank executes operations with the financial
institutions in its area, although these operations
are coordinated by the ECB.
The main difference in the tools used by the
two central banks is in the system of overnight loans
made to financial institutions. These are referred to
as discount window loans by the Federal Reserve
and the marginal lending facility by the ECB.28 In
the United States, the board of directors of each
Fed Bank sets the discount rate (the interest rate it
charges on overnight loans to financial institutions)
subject to approval of the Board of Governors.29
27

Two major exceptions have occurred in the last few years. The first
was at the end of December 1999, when, as a Y2K precaution, the
Federal Reserve allowed the federal funds rate to fall to ensure adequate
liquidity for banks. The second was in the aftermath of September 11,
2001, when again the Federal Reserve allowed the federal funds rate
to fall sharply to provide liquidity to banks.
The discount window discussed in the text refers to the provision of
adjustment credit, that is, credit extended to meet short-term liquidity
needs of financial institutions. The regional banks also make discount
window loans for seasonal and extended credit, at rates above the
discount rate for adjustment credit. Extended credit is used in conjunction with the Federal Reserve’s lender-of-last-resort function.
Originally discount rates varied across Districts. But with the emergence of a national credit market, the Federal Reserve maintains a
uniform discount rate.

Figure 6

ECB Key Interest Rates and the Euro
Overnight Index Average Rate (EOINA)
January 1, 1999, to September 20, 2002
Percent
5.75
5.25

Marginal Lending
Rate

4.75
4.25
3.75

Refinancing Rate

3.25

EONIA

2.75
2.25

Deposit Rate

1.75
1.25
Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul
99 99 99 99 00 00 00 00 01 01 01 01 02 02 02

The discount rate is set below the federal funds rate
target, yet very little borrowing occurs.30 This is
because the Federal Reserve discourages borrowing
at the discount window.31
The marginal lending facility operated by the
ECB also provides overnight loans to financial
institutions. The marginal lending rate is the rate at
which financial institutions may borrow from the
national central banks. It is set by the Governing
Council and is always above the main refinancing
rate.32 In contrast to the constraints of the discount
window, banks are allowed to freely borrow from
this facility.33
The ECB operates another standing facility in
addition to the marginal lending facility. The deposit
facility allows banks to deposit funds overnight at
the national central banks and earn interest on these
deposits. These deposits are beyond those required
to meet the minimum reserve requirement, discussed here later. The Federal Reserve also allows
30

In recent years the policy has been to set the discount rate 50 basis
points below the federal funds rate target.

An exception occurred on September 11, 2001, when the Federal
Reserve encouraged use of the discount window following disruptions
in the federal funds market.

The marginal lending rate most often has been set at 100 basis points
above the main refinancing rate.

Banks must have adequate collateral to borrow, as is also required
for discount window loans.

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banks to deposit excess reserves at the District Banks
but does not pay interest on these reserves. The ECB
deposit rate is set below the marginal refinancing
rate, and typically the two standing facility rates
form a symmetric band around the main refinancing
rate, as shown in Figure 6.
More importantly, because banks are allowed
to freely deposit and borrow through the standing
facilities, the deposit rate and the marginal lending
rate form a band around the euro overnight index
average rate (EOINA), the overnight interbank rate.
No bank will borrow money from another bank if
it can borrow at a lower interest rate from the ECB,
so the marginal lending rate sets the upper bound
for EOINA. No bank will lend money at a lower
interest rate than it can get by depositing money at
the ECB, so the deposit rate sets the lower bound
for EOINA, as shown in Figure 6.
The Federal Reserve has proposed changing
the discount window by setting the discount rate
100 basis points above the federal funds rate target
and not restricting borrowing.34 This would discourage borrowing through a pricing mechanism rather
than through the current administrative process. At
the same time, the discount window would provide
a source of funds when the money market tightens,
raising the federal funds rate above its target. The
discount rate would also act as a ceiling on the
federal funds rate. The proposed changes would
make the discount window function similar to the
ECB’s marginal lending rate.
The Federal Reserve has expressed its support
for paying interest on overnight deposits.35 Although
several bills have been introduced in Congress in
recent years to permit this, none have been passed.
Both central banks have established minimum
reserve requirements for financial institutions. These
are not now used as an active policy tool, as adjustments are infrequent. The Maastricht Treaty gave
the Governing Council the right but not the obligation
to set reserve requirements. The Federal Reserve
Act, as amended by the 1980 Depository Institutions
Deregulation and Monetary Control Act, requires
the Federal Reserve to impose minimum reserve
requirements on all depository institutions. The
1980 amendments also established the ranges for
these requirements. The Federal Reserve may, however, temporarily suspend the reserve requirements
(Section 11C).
34

See Madigan and Nelson (2002).

See, for example, Meyer (2001).

J A N UA RY / F E B R UA RY 2 0 0 3

Making Monetary Policy Decisions
Monetary policy decisions for the United States
and the euro area are made by the FOMC of the
Federal Reserve and the Governing Council of the
ECB, respectively. The FOMC consists of the seven
members of the Board of Governors, the president
of the Federal Reserve Bank of New York, and four
other District Bank presidents who serve on a rotating basis.36 Each District is grouped with one or
two others as follows: Boston, Philadelphia, and
Richmond; Cleveland and Chicago; Atlanta, Dallas,
and St. Louis; and, Minneapolis, Kansas City, and
San Francisco. The presidents of all 12 District Banks
attend and participate in the policy deliberations
of the FOMC, but only the members of the Board
and the five presidents may vote on policy actions.
The membership of the Governing Council of the
ECB is much simpler, consisting of the six members
of the Executive Board and all 12 euro area governors.
By law the Governing Council is required to
meet at least ten times per year while the FOMC is
required to meet only four times per year. Since its
inception the Governing Council has generally met
twice per month. This is far more than the FOMC,
which since 1981 has scheduled eight meetings per
year. Perhaps as a result, the FOMC has more often
added meetings (generally through teleconferencing)
to react to economic factors that have arisen during
the intermeeting period. For example, the FOMC
held three such meetings during 2001 (although
these were the first since October 15, 1999). The
only time the Governing Council has added a meeting was on September 17, 2001, to join the Federal
Reserve in cutting interest rates as U.S. stock markets
reopened following the September 11, 2001, terrorist
attacks.
If eight meetings per year may sometimes be
too few, 24 meetings per year may be too many. In
November 2001, the Governing Council decided to
generally limit its monetary policy discussions to
36

When the FOMC was created by a 1933 amendment to the Federal
Reserve Act, it consisted of “as many members as there are Federal
reserve districts” (Section 12A). The board of directors of each Reserve
Bank selected the representative from that District. Members of the
Board of Governors were permitted to attend the meetings. In 1935
membership was changed to include “the members of the Board of
Governors of the Federal Reserve System and five representatives of
the Federal Reserve banks” (Section 12A). In 1942, New York was given
a permanent position on the FOMC and the current groupings for
the other Districts were established. In addition, the representative
chosen by the board of directors of each District Bank had to be either
the president or vice president of the Bank (BOG, 2000).

Pollard

FEDERAL RESERVE BANK OF ST. LOUIS

Table 3
Typical Attendees at a Meeting of the FOMC and the Governing Council
FOMC

Governing Council

12 members of FOMC

18 members of the Governing Council

7 other District Bank presidents

Translators

12 District research directors

Minute taker

Secretary of the FOMC

European Commissioner for Monetary Affairs, possibly

Deputy Secretary of the FOMC

Chair of the euro area finance ministers, possibly

2 assistant secretaries
Manager of System Open Market Account
Director of Research and Statistics, Board of Governors
Director of the Division of International Finance,
Board of Governors
Director of Monetary Affairs, Board of Governors
General Counsel
Deputy General Counsel
Other Board staff
SOURCE: Minutes of the FOMC and Haring and Barber (2002).

the first meeting of each month. As explained by
Duisenberg (2001):
We have the impression that the bi-monthly
meetings of the Governing Council also lead,
every two weeks, to speculation in the markets and higher volatility in exchange rates
and market interest rates than would be the
case if we had a calmer rhythm of meetings.
The second monthly meeting is still held but now
focuses on issues related to the other tasks of the
ECB.
Preparing for Policy Meetings. Generally on
the Thursday preceding a Tuesday FOMC meeting,
members of the FOMC and the other District Bank
presidents receive the Greenbook, a report on the
state of the economy prepared by the Board of
Governors staff and named for the color of its
cover. The Greenbook contains the Board staff’s
analysis of current economic conditions as well as
a forecast of the economy.37 A few days later the
Bluebook arrives. This report, also prepared by the
Board staff and also named after the color of its
37

District Bank presidents are also briefed by their staff economists
prior to meetings of the FOMC. Only limited numbers of the District
staff are allowed to see the reports prepared by the staff at the Board
of Governors.

cover, summarizes conditions in financial markets
and lists the policy options. Two or three options
are given, one of which is always to make no change
in policy.38
About two days prior to the Thursday monetary
policy meeting, members of the Governing Council
receive a copy of the Orangebook (again, named for
the color of its cover), prepared by the ECB’s chief
economist (currently Ottmar Issing), who is also a
member of the Executive Board.39 The Orangebook,
like the Greenbook, provides an analysis of economic
and monetary conditions. In contrast to the Bluebook, it provides not a range of policy options, but
a policy recommendation.
The Policy Meeting.40 The meetings of the
Governing Council are more informal than those
of the FOMC, with fewer attendees and fewer formal
presentations. Table 3 lists the attendees at a typical
meeting of the two policymaking boards. With the
38

A detailed discussion of the FOMC meeting is given by Meyer (1998).
Poole (1999) and Nash (2002) also provide insights into the workings
of the FOMC.

Information on the meetings of the Governing Council is from Haring
and Barber (2002).

The proceedings of a monetary policy meeting, particularly with
respect to the policy discussion, often reflect the style of the head of
the central bank.

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exception of translators, there are normally no more
than 21 attendees at the meetings of the Governing
Council.41 The meetings of the FOMC typically
have between 50 and 60 attendees.
Monetary policy meetings of the Governing
Council open with a presentation by the ECB’s chief
economist on the economic outlook report from the
Orangebook. The other members of the Governing
Council then present their views on policy. The ECB
president summarizes the discussion and attempts
to form a consensus on policy. No formal vote is
taken at the meeting.
Meetings of the FOMC begin with a presentation
by the Manager of the System Open Market Account
at the Federal Reserve Bank of New York, who discusses open market operations undertaken during
the intermeeting period as well as developments in
domestic financial markets and foreign exchange
markets.42 Next, the director of Research and
Statistics and the director of the Division of International Finance at the Board of Governors discuss
the Board staff’s forecast and international developments, respectively. Following these presentations,
the Reserve Bank presidents and the members of
the Board of Governors provide their own assessment
of economic conditions and the outlook. The next
part of the meeting focuses on a discussion of policy.
The director of Monetary Affairs at the Board outlines the policy options given in the Bluebook. The
Chairman then presents his policy preference. This
is followed by an open discussion by members of
the FOMC and the other District Bank presidents. At
the close of this discussion the Chairman summarizes the discussion. He then reads a policy directive
that reflects the view of the committee. The members
of the FOMC vote on the policy directive.

INDEPENDENCE, ACCOUNTABILITY,
AND TRANSPARENCY
In establishing the European System of Central
Banks, policymakers endowed it with a high degree
of independence from the governments of the member states and the European Union. The Governing
Council, for example, was given explicit control
over the tools of monetary policy and is prohibited
from taking advice from the governments of the
euro area. Even the nonrenewable term of office of
41

According to Haring and Barber (2002), although translators are
available, English is the common language of the Governing Council
meetings.
Information in this section comes from Meyer (1998).

J A N UA RY / F E B R UA RY 2 0 0 3

members of the Executive Board was designed to
protect them from political interference.43 The
Maastricht Treaty not only guaranteed the independence of the ECB, but also required that the national
central banks be independent as a prerequisite for
joining the Eurosystem.
This emphasis on independence was supported
by various studies in the late 1980s and early 1990s
that showed a negative correlation between the
degree of independence of the central bank and the
country’s inflation rate.44 Moreover, studies showed
that a country did not have to sacrifice growth to
achieve a lower rate of inflation. These studies helped
fuel changes in the legal status of many central
banks, reducing the amount of direct government
control and increasing the emphasis on price stability. When the Federal Reserve Act was passed in
1913, independence of monetary policy was less
of a concern: The Secretary of the Treasury as well
as the Comptroller of the Currency were members
of the Federal Reserve Board, and the former was the
Chairman of the Board. Over time, however, the
independence of the Federal Reserve has increased.
Congress eliminated the two government positions
on the Board effective in 1936.45 The length of the
term of office for Board members was increased
from the original 10 years to 12 years in 1933 and
then to the current 14 years in 1935. A key step in
increasing the independence of the Federal Reserve
was the 1951 Federal Reserve–Treasury Accord that
released the Federal Reserve from a requirement,
begun during World War II, to maintain interest rate
ceilings on Treasury securities. This accord is seen
as establishing the independence of monetary policy.
Independence, however, is not without its drawbacks. The decisions made by central bankers can
have a profound effect on the economy and hence
the public. Central bank independence removes
these decisions from the hands of elected officials
and restricts the ability of the government to remove
43

The appointment process, however, has not been without political
meddling. When the selections for the initial Executive Board were
being made, there was a general agreement among the member governments to appoint Duisenberg as president of the ECB. France, however,
insisted that its own candidate, Jean Claude Trichet, be appointed
president. France agreed to support Duisenberg only after he agreed
to resign part way through his term. On February 7, 2002, Duisenberg
announced that he would resign on July 9, 2003, after serving slightly
more than five years of his eight-year term.

See Pollard (1993) for a review of this literature.

The 1935 amendment to the Federal Reserve Act that made this
change also changed the name of the Federal Reserve Board to the
Board of Governors of the Federal Reserve System.

FEDERAL RESERVE BANK OF ST. LOUIS

central bank officials. Thus, in democratic societies
accountability and transparency are seen as necessary to counterbalance central bank independence.
Accountability holds the central bank responsible
for its actions. Transparency, the ease with which
policy actions can be observed and understood, is
necessary for accountability. As explained by Roger
Ferguson (2001), the vice chairman of the Board of
Governors, transparency “gives the public the tools
to hold the independent central bank accountable.”

Accountability
For what should the central bank be accountable
and to whom should it be accountable? The central
bank should be held accountable for its legislative
mandate—specifically, the goals set by the government.46 Recall that the goal of the ECB is price
stability—specifically, as defined by the Governing
Council, an inflation rate of less than 2 percent over
the medium term. The goals of the Federal Reserve
are maximum employment, stable prices, and
moderate interest rates. Accountability is easier
when the central bank has a single goal, or at least
a ranking of goals; for, as explained by Meyer (2000),
multiple goals “always carry trade-offs, at least in
the short-run, which are subject to the discretion
of the central bank.” The precision of numerical
goals also aids in accountability.47
Ultimately a central bank should be accountable
to the public; but, since the public has no direct
control over the central bank, it is the obligation of
the elected representatives of the people to hold the
central bank accountable for its mandate. In the
United States, it is natural that the Federal Reserve
be accountable to Congress. Not only are the members of Congress the direct representatives of the
American people, but Congress also has the ability
to change the mandate of the Federal Reserve
through amending the Federal Reserve Act. Moreover, it was Congress that delegated its constitutional
authority to “coin money” and “regulate the value
thereof” to the Federal Reserve.48
46

This implies that a central bank has instrument independence, not
goal independence, as distinguished by Debelle and Fischer (1994)
and discussed in Meyer (2000).

Numerical goals, however, are not always easy to define. For example,
Judd and Rudebusch (1999) and Meyer (2000) point out that defining
full employment is difficult since there is no consensus on an unemployment rate that corresponds to full employment. In addition, full
employment is not a constant but varies as a result of demographics
and government policies.

See Article 1, Section 8, Clause 5 of the Constitution of the United States.

Pollard

Indeed, in 1977 Congress amended the Federal
Reserve Act to list the goals of the Federal Reserve
and to require the Board of Governors to consult
with Congress twice per year. This occurs through
the Chairman’s testimony before the Senate Banking,
Housing, and Urban Affairs Committee and the
House Banking and Financial Services Committee.
The following year Congress further amended the
Federal Reserve Act to require the Board of Governors
to submit a written report to Congress prior to the
Chairman’s appearance before the congressional
committees. This report had to include three things:
(i) an analysis of recent economic conditions, (ii)
the FOMC’s forecast of economic conditions and
monetary and credit aggregates, and (iii) the relationship between this forecast and the administration’s
forecast. The Federal Reports Elimination and Sunset
Act of 1995 terminated the legal requirement for
these semiannual reports and testimony at the end
of 1999. Nevertheless, the FOMC decided to continue the reports and testimony as it believed they
“enhanced its accountability to the public and the
Congress” (FOMC, 1999).
In December 2000 Congress amended the
Federal Reserve Act, reinstating the reporting
requirement. Section 2B now specifies that “the
Chairman of the Board shall appear before the
Congress at semi-annual hearings” and that the
Board shall submit a written report. The report is
to contain
A discussion of the conduct of monetary
policy and economic developments and
prospects for the future, taking into account
past and prospective developments in
employment, unemployment, production,
investment, real income, productivity,
exchange rates, international trade and
payments, and prices. (Section 2B (b))
Within the euro area, it is more difficult to
answer the “accountable to whom” question. The
European Parliament is a good candidate since it
represents the European public. As stated by PadoaSchioppa (2000), a member of the Executive Board,
In the political order of the European Union,
the only institution that directly derives its
role and legitimacy from the citizens is the
European Parliament…The European
Parliament is the institution of Europe’s
democratically elected representatives,
which represents the interests of the peoples
of Europe.
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Yet, unlike the relationship between the U.S.
Congress and the Federal Reserve, the European
Parliament has little authority over the ECB. The
European Parliament may request that members of
the Executive Board appear before its committees,
but has no such power over the other members of
the Governing Council (the governors of the national
central banks).49 Parliament gives advice on the
appointments to the Executive Board but has no
veto power over these, unlike the role of the U.S.
Senate.50 Furthermore, Parliament has no power to
change the laws governing the ECB. Indeed, the only
way to change the mandate of the ECB or most
other regulations regarding its operation is through
an amendment to the treaty. This requires the agreement of all 15 governments of the European Union
and then ratification of the amendments by the 15
national parliaments. In some countries passage of
a public referendum is also necessary. Furthermore,
the ECB must be consulted before any changes can
be made to its charter.
The Maastricht Treaty does require the ECB to
report annually “on the monetary policy of both the
previous and current year” (Article 113) to the
European Parliament, ECOFIN, the European Commission, and the European Council. The president
of the ECB must present the report to the European
Parliament and to ECOFIN. This requirement to
report to multiple bodies reflects the lack of a single
institution that has control over the mandate of the
central bank and represents the European public.

Transparency
Transparency in monetary policy includes three
key aspects: (i) transparency in goals, (ii) transparency
in policy decisions, and (iii) transparency in the
outlook. The first requires not only that the goals
of the central bank be clearly defined but that they
be easily understood.51 The Maastricht Treaty clearly
identifies the goal of the ECB—price stability. The
Governing Council further clarified this goal by
giving a quantitative definition to price stability.
49

Currently, once per quarter the ECB President appears before the
European Parliament Committee of Economic and Monetary Affairs
to explain the recent policy decisions of the Governing Council.
The U.S. Senate has no input into the appointments of the presidents
of the District Banks nor does the European Parliament have any input
into the appointments of the heads of the national central banks. On
the FOMC, members of the Board of Governors outnumber the presidents; on the Governing Council, the governors of the national central
banks outnumber the members of the Executive Board.
See Judd and Rudebusch (1999).

J A N UA RY / F E B R UA RY 2 0 0 3

Since deviations from price stability at a point in
time are not necessarily indicators of a failure of
policy, the ECB also sets a monetary aggregate target
as a way to determine whether its policies are likely
to be successful.
The goals of the Federal Reserve are stated in
the Federal Reserve Act; but, as noted here previously,
these goals are neither defined nor ranked. The
FOMC was required to set monetary aggregate targets
by the Federal Reserve Act; when this requirement
expired at the end of 1999, however, it abandoned
the practice.
Transparency also requires that policy decisions
be communicated to the public in a clear way along
with the reasoning behind the decisions. The ECB
issues a press release and the president of the ECB
holds a news conference (also attended by the vice
president) following the monetary policy meetings
of the Governing Council.52 The press release
announces any changes in the main refinancing,
marginal lending, and deposit rates. At the press
conference the President gives an overview of economic conditions and the outlook for the euro area
to provide a framework for the policy decision. The
ECB also publishes a monthly bulletin discussing
any policy changes as well as economic conditions
in the euro area.53
The Federal Reserve also issues a press release
following each FOMC meeting, but does not hold a
news conference. Perhaps, as a result, the press
release is more detailed than that of the Governing
Council.54 The press release begins with an
announcement of any change in the federal funds
rate target. It then provides a brief overview of
economic conditions and the reason for any policy
change. Since March 2002, the release has included
the vote of the FOMC. If any member dissents from
the approved policy action, the member is named
and the preferred policy action is noted. The release
also states any changes in the discount rates along
with a list of Districts requesting the change.
A day or so following its next scheduled meeting,
the FOMC releases the minutes of the previous
52

Prior to 2001, when the Governing Council met twice per month to
formulate monetary policy, the press conference was held only after
one of the monthly meetings.

The press releases, transcripts of the press conference, and bulletin
are available at <www.ecb.int>.

See the boxed insert “Press Releases Following Meetings of the FOMC
and the Governing Council” for a comparison of recent press releases
by the two central banks.

Pollard

FEDERAL RESERVE BANK OF ST. LOUIS

PRESS RELEASES FOLLOWING POLICY MEETINGS OF THE
FOMC AND GOVERNING COUNCIL
Federal Reserve Press Release
Release Date: September 24, 2002
For immediate release

The Federal Open Market Committee decided today to keep its target for the federal funds rate unchanged
at 1 3/4 percent.
The information that has become available since the last meeting of the Committee suggests that
aggregate demand is growing at a moderate pace.
Over time, the current accommodative stance of monetary policy, coupled with still robust underlying
growth in productivity, should be sufficient to foster an improving business climate. However, considerable
uncertainty persists about the extent and timing of the expected pickup in production and employment
owing in part to the emergence of heightened geopolitical risks.
Consequently, the Committee believes that, for the foreseeable future, against the background of its
long-run goals of price stability and sustainable economic growth and of the information currently
available, the risks are weighted mainly toward conditions that may generate economic weakness.
Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; William J. McDonough,
Vice Chairman; Ben S. Bernanke; Susan S. Bies; Roger W. Ferguson, Jr.; Jerry L. Jordan; Donald L. Kohn;
Mark W. Olson; Anthony M. Santomero, and Gary H. Stern.
Voting against the action were: Edward M. Gramlich and Robert D. McTeer, Jr.
Governor Gramlich and President McTeer preferred a reduction in the target for the federal funds rate.

ECB Press Release
Monetary policy decisions
12 September 2002

At today’s meeting the Governing Council of the ECB decided that the minimum bid rate on the main
refinancing operations and the interest rates on the marginal lending facility and the deposit facility
will remain unchanged at 3.25%, 4.25% and 2.25% respectively.
The President of the ECB will comment on the considerations underlying these decisions at a press
conference starting at 2.30 p.m. today.

meeting.55 The minutes provide a more detailed
summary of the economic conditions, outlook,
and reasons underlying the policy stance adopted
at the meeting. The minutes do not ascribe policy
views to any particular member of the FOMC except
in the case of a dissenting vote.
The ECB does not release minutes of its meetings
55

The press release and minutes are available at <www.federalreserve.
gov/fomc>.

nor are there formal votes. Every year the European
Parliament has passed a resolution calling on the
ECB to publish the minutes of Governing Council
meetings. Members of the Governing Council argue
that releasing minutes would limit the exchange of
ideas that occur at the meeting and furthermore that
the press conference already provides a summary
of the meeting.56 The European Parliament has
56

See, for example, Hämäläinen (2000).

J A N UA RY / F E B R UA RY 2 0 0 3

Pollard

also called on the Governing Council to vote and
to include in the minutes a summary of the vote
without listing names. Duisenberg (2002) has
argued that listing the dissenting views even
anonymously “could lead to undue pressure on
national central bank governors to deviate from a
euro area perspective.”
Transparency in policy also extends to the outlook for the economy. Understanding the central
bank’s outlook for the economy provides a guide
to future policy moves. The Federal Reserve releases
two types of information regarding its outlook for
the economy. In its semiannual report to Congress
it publishes the range and central tendency of the
individual forecasts of the members of the Board of
Governors and the presidents of the District Banks
with respect to output, inflation, and unemployment
for the current and following year. Since February
2000 the press release issued by the FOMC includes
a balance of risks statement that indicates
how the Committee assesses the risks of
heightened inflation pressures or economic
weakness in the foreseeable future. This time
frame in the new language is intended to
cover an interval extending beyond the next
FOMC meeting. (Federal Reserve Press
Release, January 19, 2000)
The balance of risks statement (particularly shifts
in the balance) is viewed as an indicator of future
policy by the FOMC.57
The ECB initially resisted publishing forecasts,
but began including them in its Monthly Bulletin in
December 2000. Neither the Federal Reserve nor
the ECB publishes detailed forecasts like the staff
forecasts of the Board of Governors.

CONCLUSION
Central banking is often described as an art, not
a science. As a result there is no blueprint for the
structure and operations of a central bank. Although
the structures of the Federal Reserve System and
the Eurosystem are similar, there are many differences in the way they operate. The Eurosystem is
more decentralized than the Federal Reserve, with
more tasks left to the national central banks. Even
the conduct of monetary policy is more decentralized. Open market operations in the United States
are conducted only by the Federal Reserve Bank of
New York, following discussion between the staff at
57

See Rasche and Thornton (2002).

J A N UA RY / F E B R UA RY 2 0 0 3

REVIEW

the Open Market Desk and at the Board of Governors.
In the Eurosystem each national central bank carries
out open market operations, although these are
coordinated with the ECB.
The Board of Governors has more control over
the appointments of the presidents of the District
Banks than the Executive Board has over appointments of the heads of the national central banks.
In the United States, the District Bank presidents
must be approved by the Board of Governors. In
Europe the national governments alone determine
the heads of the national central banks.
Of course, the structure of central banks is not
static. Over its 90-year history, the legislation governing the Federal Reserve has been amended numerous
times. Although the laws governing the Eurosystem
are more cumbersome to amend, if it follows the
path of the Federal Reserve then centralization will
increase over time.
Transparency has also increased. Not so many
years ago monetary policy was shrouded in secrecy.
Central banks seemed to make every effort to prevent monetary policy from being comprehensible
to the general public. Initially, measures aimed at
greater transparency were often imposed upon
central banks. Perhaps surprising, central banks
themselves have become champions of transparency, for transparency not only has proved to
be helpful in making central banks more accountable but also has had the added benefits of increasing
the credibility and predictability of monetary policy.
As put by William Poole (2001), president of the
Federal Reserve Bank of St. Louis, “we expect better
public policy outcomes from a transparent process.”
Disagreements remain over how to best make
policy transparent while at the same time preserving
the independence of the central banks. The Federal
Reserve, for example, has recently begun publishing
the roll call on the policy directive immediately
following an FOMC meeting. If there is a dissent the
action preferred by the dissenter(s) is also given. The
ECB not only does not publish the vote, but also does
not have a formal vote on policy at the Governing
Council meetings. It is concerned that, given the
multinational character of the Eurosystem, any
knowledge of voting would lead to political pressure
on the representatives of the national central banks.
Over time, as the credibility and independence of
the Eurosystem becomes established, it is likely
that such concerns will fade.

FEDERAL RESERVE BANK OF ST. LOUIS

Pollard

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___________. The European Central Bank. March 2001c.
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___________. Protocol (No. 18) on the Statute of the European
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Federal Reserve Bank of Minneapolis. “The Districts Take
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Ferguson, Roger W. Jr. “Transparency in Central Banking:
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default.htm>.
Greenspan, Alan. Opening remarks in “Achieving Price
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August 1996, pp. 1-5. <www.kc.frb.org/PUBLICAT/
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The Region, September 2001, 15(3), pp. 24-27, 55-65.
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Presented at the 32nd Annual Conference of the Money,
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key/00/sp000908_1.htm>.
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Recessions and Recoveries. Washington, DC: International
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Monetary Policy.” Federal Reserve Bank of San Francisco
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html>.
King, Mervyn. “How Should Central Banks Reduce
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SYMPOS/1996/pdf/s96king.pdf>.
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Speech at the London School of Economics, Financial
Markets Group, 24 February 1999. <www.ecb.int/key/
sp990224.htm>.
___________. “An Institutional Glossary of the Eurosystem.”
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Economic Performance.” Federal Reserve Bank of St. Louis
Review, July/August 1993, 75(4), pp. 21-36.
___________. “EMU: Will It Fly?” Federal Reserve Bank of
St. Louis Review, July/August 1995, 77(4), pp. 3-16.
Poole, William. “Communicating the Stance of Monetary
Policy.” Speech at the University of Missouri, Columbia,
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1999/11_04_99.html>.

Meulendyke, Ann-Marie. United States Monetary Policy and
Financial Markets. Federal Reserve Bank of New York, 1998.

___________. “Central Bank Transparency: Why and How?”
Presented at the Federal Reserve Bank of Philadelphia
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news/speeches/2001/11_30_01.html>.

Meyer, Laurence H. “Come with Me to the FOMC.” Gillis
Lecture, Willamette University, Salem, Oregon, 2 April
1998. <www.federalreserve.gov/boarddocs/speeches/
1998/199804022.htm>.

Prati, Alessandro and Schinasi, Garry J. “Ensuring Financial
Stability in the Euro Area.” Finance and Development,
December 1998, 35(4), pp. 12-15.

___________. “The Politics of Monetary Policy: Balancing
Independence and Accountability.” Remarks at the
University of Wisconsin, LaCrosse, Wisconsin, 24 October
2000. <www.federalreserve.gov/boarddocs/speeches/
2000/20001024.htm>.
___________. “Payment of Interest on Reserves.” Testimony
before the Financial Services Subcommittee on Financial
Institutions and Consumer Credit, U.S. House of
Representatives, 13 March 2001. <www.federalreserve.
gov/boarddocs/testimony/2001/20010313/default.htm>.
Nash, Betty Joyce. “The Federal Open Market Committee:
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Richmond Region Focus, Summer 2002, 6(2/3). <www.
rich.frb.org/pubs/regionfocus/summer02/fomc.html>.

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Primm, James Neal. A Foregone Conclusion: The Founding
of the Federal Reserve Bank of St. Louis. St. Louis: Federal
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publications/foregone>.
Pringle, Robert, ed. The Morgan Stanley Dean Witter
Central Bank Directory 2002. London: Central Banking
Publications, 2002.
Rasche, Robert H. and Thornton, Daniel L. “The FOMC’s
Balance-of-Risks Statement and Market Expectations of
Policy Actions.” Federal Reserve Bank of St. Louis Review,
September/October 2002, 84(5), pp. 37-50.
Wellnik, A.H.E.M. “European Economic and Monetary
Cooperation from an Historical Perspective.” BIS Review,
16 April 1997.

Was Y2K Behind the Business Investment
Boom and Bust?
Kevin L. Kliesen
ccording to the Business Cycle Dating
Committee of the National Bureau of
Economic Research, the nation’s recordlong business expansion ended in March 2001,
exactly 10 years after it started. Much of the downturn in the growth of U.S. economic activity during 2001 can be traced to a sharp decline in business purchases of information processing equipment and software, otherwise known as high-tech
capital goods. This investment bust came on the
heels of a boom in spending on those same types
of capital goods over the latter part of the 1990s.
Although business fixed investment spending
tends to be pro-cyclical, this time the boom and
bust was unusually large. One explanation for the
boom and bust that has not been explored in
much detail was the surge in business purchases
of hardware and software in preparation for the
century date change (hereafter, Y2K). Was the
boom due to efforts by firms to upgrade their
computer hardware and software? Likewise, was
the bust caused by the cessation of Y2K-related
capital spending?

RECENT TRENDS IN BUSINESS FIXED
INVESTMENT SPENDING
In the national income and product accounts
(NIPA), nonresidential investment (or business fixed
investment [BFI]) comprises investment in structures
and investment in equipment and software (E&S).
Over the past 25 years, fixed investment in structures
as a share of total BFI has dropped from about 33
percent to 27 percent, so that, accordingly, business
investment in E&S as a share of BFI has grown from
about 67 percent to about 73 percent. Figure 1 shows
that there has been a marked shift in the composition of E&S investment since 1977.1 Business expenditures on E&S investment are classified under four
categories: (i) information processing equipment
Kevin L. Kliesen is an economist at the Federal Reserve Bank of St. Louis.
The author thanks Dave Wasshausen of the Bureau of Economic
Analysis and Robert Parker of the General Accounting Office for helpful
comments. Thomas A. Pollmann provided research assistance.

and software (IPES), (ii) transportation equipment,
(iii) industrial equipment, and (iv) other. In 1977,
each amounted to roughly 17 percent of total BFI.
By mid-2000, IPES investment as a share of BFI
had grown to a little less than 36 percent, while the
remaining components had smaller shares than
they did in 1977.
Figure 2 shows that increased spending on
software accounted for the bulk of the increase in
IPES investment spending. From 1977 to late 2001,
the share of software investment rose from a little
more than 15 percent to nearly 47 percent. Over
this period, the share of fixed investment in computers rose markedly less, from about 15 percent
to about 18 percent.
In terms of its contribution to real GDP growth,
the investment boom in the high-tech sector was
largely a phenomenon of the late 1990s. Real IPES
investment grew at a little more than 12 percent per
year from 1990 to 1995. This rate of growth accelerated to a little more than 19 percent per year from
1995 to 2000, so that by the fourth quarter of 2000
it was at an all-time high as a share of BFI (Figure 1).
Not surprisingly, the contribution to real GDP growth
from IPES, as seen in Table 1, increased measurably
during the latter half of the 1990s. From 1990 to
1995, growth of BFI contributed 0.4 percentage
points of the 2.3 percent growth per year of real
GDP. From 1996 to 2000, though, the contribution
of real BFI jumped to 1.2 percent per year, a bit less
than a third of the 4.0 percent per year growth of
real GDP. During this period, the largest contribution
to real BFI growth stemmed from E&S investment
(averaging 1.0 percentage points). The contribution
from business structures, industrial, and transportation equipment was relatively small.
Beginning in the second half of 2000, businesses
started to scale back their purchases of most types
of capital goods—not just high-tech equipment
and software (IPES). Indeed, over the four quarters
1

Because chain weights do not have the additive and multiplicative
properties of fixed weights, it is not correct to express shares in real
terms. Thus, Figure 1 expresses shares in current (nominal) dollars.
See Whelan (2000).

J A N UA RY / F E B R UA RY 2 0 0 3

REVIEW

Kliesen

Figure 1
E&S Investment as a Share of Nonresidential Fixed Investment
0.40

0.30
IPES

0.20
Transportation
Industrial
Other
0.10
1977

1982

1987

1992

1997

2002

NOTE: Shares expressed in current (nominal) dollars.

CONVENTIONAL EXPLANATIONS OF
THE INVESTMENT BOOM AND BUST

Figure 2
Composition of IPES Fixed Investment
100

80
Other
60

Software

Computers and Peripherals

0
1977

1982

1987

1992

1997

2002

NOTE: Shares expressed in current (nominal) dollars.

of 2001, real fixed investment in business structures
fell 10.6 percent, about the same as the decline in
IPES investment (10.5 percent); real investment in
E&S fell less, roughly 9 percent. As seen in Table 1,
of the 3.7-percentage-point decline in real GDP
growth from 1996-2000 to 2001, nearly half (1.6
percentage points) stemmed from the swing in E&S
investment, with IPES investment comprising the
bulk of that (1 percentage point).
32

J A N UA RY / F E B R UA RY 2 0 0 3

Firms will invest (i.e., purchase capital equipment) in order to increase their future profit opportunities. Hence, a firm’s decision to invest will depend
on its projection of those future profit opportunities
(expected future returns) and the cost of making
the investment (cost of capital). In terms of explaining the recent investment boom and bust, it might
be useful to consider two competing explanations.
One explanation is that the investment boom may
have simply been a cyclical phenomenon. That is,
expected returns to investment rose as economic
growth accelerated. Moreover, rapidly advancing
technology and declining prices of information
technology goods lowered the cost of capital for
high-tech capital goods relative to other capital
goods, boosting investment in information processing and communications equipment.
Another explanation suggests that the investment bust came about as aggregate demand growth
weakened in 2000 and 2001 in response to the
sharp declines in equity prices, especially those of
technology stocks. Second, expected returns during
the latter part of the 1990s may have risen because
of problems associated with Y2K. That is, the opportunity cost of not fixing potential computer and
software problems was high. Failure to fix the problems may have resulted in disruptions to business
activity and, hence, lower profits. Once these Y2K

Kliesen

FEDERAL RESERVE BANK OF ST. LOUIS

Table 1
Real BFI Contributions to Real GDP Growth (Percentage Points)

Real GDP Growth

1970-79

1980-89

1990-95

1996-2000

2001

3.3

3.0

2.3

4.0

0.3

Contributions from:
Nonresidential fixed investment

0.6

0.4

1.2

–0.7

Structures

0.1

–0.1

0.2

–0.1

Equipment and software

0.5

0.3

0.5

1.0

–0.6

0.3

0.4

0.3

0.7

–0.3

Computers and peripherals

0.1

0.2

0.3

0.0

Software

0.0

0.1

0.2

0.0

Other

0.1

0.2

–0.2

0.1

0.0

0.1

–0.1

Information processing

Industrial equipment
Transportation equipment

0.1

0.0

0.1

–0.2

Other

0.1

0.0

0.1

0.0

NOTE: Percentages are averages of years indicated (subject to rounding errors).

problems were addressed, the expected returns
were zero and these types of investment ceased.

Was There Excess Investment During
the 1990s?
The substantial decline in investment spending
beginning in late 2000—both high-tech and nonhigh-tech—led some to conclude that firms overinvested in capital goods during the latter part of
the 1990s.2 Excess investment is usually thought
of as the amount of capital goods (in the aggregate)
that exceeds the amount that businesses require to
produce the existing demand for goods and services.
In the context of the firm’s investment decision
noted above, it is useful to think of excess investment as the result of firms overestimating future
profit opportunities (expected returns) in the present
relative to the existing cost of capital. During the
latter half of the 1990s and into early 2000, excess
investment may have occurred because firms
expected the rapid rate of aggregate growth to
persist longer than it did.
Figure 3 provides some evidence that there may
have been excess business investment in IPES. In
Figure 3, the levels of real IPES investment are
indexed to 100 for each of the post-World War II
2

In some circles, this was termed a “capital overhang.” See Council of
Economic Advisers (2002) or French, Klier, and Oppedahl (2002).

Figure 3
Real IPES
All Peak Values Indexed to 100
115
110
105
100
95
90
Historical Average (Post 1960)
2001 Recession

85
80
75
–4

–3

–2

0
–1
1
Quarters from Peak

NOTE: The shaded area represents the range of previous recessions.

business cycle peaks (excluding the 1980 and 2001
peaks). The average of these indexed levels is plotted (solid line), as is the indexed level for the most
recent period (2000-01)(dotted line). Relative to previous peaks (as defined by the National Bureau of
Economic Research), IPES investment was exceptionally strong just before the 2001 recession,
J A N UA RY / F E B R UA RY 2 0 0 3

REVIEW

Kliesen

Table 2
Was There Excess Investment During the 1991-2001 Expansion? (Percentage Deviations from Trend)
Expansion period

Business
structures

IPES

Industrial
equipment

Transportation
equipment

Residential

1961:Q2 to 1969:Q4
Average deviation

–0.44

–0.97

–0.87

0.17

–0.73

High

8.56

10.59

9.48

13.07

13.23

Low

–8.55

–9.98

–13.90

–15.08

–22.99

High – Low

17.11

20.58

23.39

28.15

36.22

1.07

1.45

–3.29

–1.25

8.40

1970:Q4 to 1973:Q4
Average deviation
High

8.77

9.29

11.74

16.11

18.41

Low

–3.46

–5.41

–12.01

–32.48

–8.64

High – Low

12.23

14.70

23.74

48.59

27.05

–3.48

–3.23

–1.66

–0.26

0.03

5.64

4.09

9.11

16.58

15.43

–10.03

–13.34

–9.26

–23.53

–35.85

15.66

17.43

18.37

40.12

51.28

–0.40

0.86

–0.20

0.44

2.04

1975:Q1 to 1980:Q1
Average deviation
High
Low
High – Low
1982:Q4 to 1990:Q3
Average deviation
High
Low
High – Low

8.48

7.99

8.89

8.96

8.29

–14.77

–15.28

–16.41

–19.93

–29.61

23.25

23.26

25.30

28.89

37.91

1991:Q1 to 2001:Q1
Average deviation

–1.01

–0.95

–1.04

–0.97

–1.33

High

5.65

4.77

4.86

10.06

8.13

Low

–6.45

–6.17

–9.27

–15.69

–20.73

High – Low

12.10

10.94

14.13

25.75

28.86

NOTE: Percentages are calculated as deviations from trend in chain-weighted dollars. The trend value is estimated from the HodrickPrescott algorithm. See footnote 5. Sample period for Hodrick-Prescott calculations is 1947:Q1 to 2001:Q1 for all categories except
IPES, which begins in 1959:Q1.

before falling off considerably.3 In fact, the figure
suggests that the high-tech investment boom and
bust of 2001-02 was the largest in the post-World
War II period.
There are other ways to ascertain whether there
was excess investment toward the end of the 19912001 expansion. One method is to compare the
desired aggregate capital stock to the actual capital
3

IPES data are available only back to 1959 at a quarterly frequency.
Calculations exclude the short 1980 recession.

J A N UA RY / F E B R UA RY 2 0 0 3

stock (the linkage between the two, of course, is
investment spending). A difficulty with this approach
is that the desired capital stock can only be estimated
from an econometric model.4 Another method of
ascertaining whether excess investment occurred
is to calculate the percentage deviation of the actual
4

Macroeconomic Advisers (2002) found that the actual stock of IPES
capital exceeded the desired stock by a little more than 6 percent during
the fourth quarter of 2000 (the largest deviation of the 1991-2001
expansion). This estimate was calculated prior to the 2002 annual
revisions of the NIPA data.

Kliesen

FEDERAL RESERVE BANK OF ST. LOUIS

level of real fixed investment from the trend level.5
Table 2 shows these percentage deviations for real
fixed investment in business structures, IPES, industrial equipment, transportation equipment, and
residential investment for each U.S. business expansion since 1960.
One aspect of the typical business expansion
that is seen from Table 2 is that real investment is
highly volatile. This is illustrated by the difference
between the high and low percentage deviations
from trend (at a quarterly frequency). In the 1982-90
expansion, for example, real IPES investment relative
to its trend ranged from –15.3 percent to +8.0 percent. Even larger percentage deviations from trend
were seen in previous expansions and among other
forms of fixed investment. Thus, if a large, positive
percentage deviation from trend is viewed as a sign
of excess investment, excessive investment during
the 1991-2001 expansion was atypical in that it was
comparatively mild. The largest positive deviation
occurred in transportation equipment (10.1 percent).
This was relatively small compared with the deviation in the 1961-69, 1970-73, and 1975-80 expansions, but it exceeded the deviation in the 1982-90
expansion. For the 1991-2001 expansion, positive
deviations from trend of similar size were noted in
business structures, industrial equipment, and residential fixed investment. Thus, it does not appear
that excess IPES investment was particularly noteworthy. The largest positive percentage deviation
from trend occurred in the second quarter of 2000,
but it was small (4.77 percent) compared with previous expansions, such as the 1961-69 (10.59 percent) and 1982-90 (7.99 percent) expansions.
While the evidence from Table 2 suggests that
the investment boom in the 1990s was not excessive,
the data from Table 1 nonetheless show that the
surge in BFI spending contributed appreciably to
real GDP growth. One popular explanation for the
recent investment boom is the acceleration in labor
productivity growth beginning around 1995, which
some have dubbed the “New Economy” story and
which ties in with the rise in corporate equity prices
in the latter half of the 1990s.6
5

The trend was calculated using the Hodrick-Prescott filter, a statistical
smoothing algorithm used to estimate the long-term trend component
of a time series. The Hodrick-Prescott filter removes movements that
are thought to arise merely from changes associated with the business
cycle. The calculation here was done in EViews Version 4.0.

See Greenspan (1998).

The New Economy Story
Beginning around 1995, prices for computers
and peripherals began to fall sharply. After falling
an average of 12.8 percent per year from 1990 to
1994 (annual data), computer prices fell an average
of 24.1 percent per year from 1995 to 1999. Bolstered by falling prices, expenditures (output) on
high-tech capital goods rose sharply.7 From 1995
to 2000 (annual data), production of high-tech
equipment rose an average of roughly 40 percent
per year, after growing an average of a little more
than 21 percent per year from 1990 to 1995.8 The
increased amount of high-tech capital equipment
available to workers (capital deepening) raised their
labor productivity.9
A potential key impetus behind the investment
boom during this period was the sharp rise in corporate equity prices. All else equal, rising equity prices
lower the (equity) cost of capital, which, by lowering the hurdle rate that separates profitable from
unprofitable investments, spurs firms to increase
their level of fixed capital investment (and output).
Figure 4 indicates that corporate equity prices during
the late 1990s rose the most among those publicly
traded firms generally thought of as both users and
producers of information technology (IT) capital
goods such as computers, semiconductors, and software. From October 8, 1998, to March 10, 2000, the
technology-heavy Nasdaq composite index rose
nearly 260 percent to just under 5050. Over the
same period, the Wilshire 5000 index rose from
about 8,621 to a little more than 13,952, an increase
of about 62 percent; while noteworthy, this increase
is a far cry from 260 percent. The larger increase in
the Nasdaq composite index (decline in the cost of
7

Pakko (2002) tackles the thorny issue of whether improvement in the
quality of high-tech capital goods—as reflected in the sharp declines
in relative prices of computers and other information technology
equipment—was overstated. If true, this would overstate the growth
of real capital spending. He finds that generally not to be the case.

High-tech is defined as non-energy output of computers, communications equipment, and semiconductors. See the Federal Reserve Board’s
G.17 statistical release (Industrial Production and Capacity Utilization).

Surveying five prominent studies, Stiroh (2002) found that the contribution of IT-related investment—both the production and use of IT
capital goods—explained a substantial portion of the roughly 1percentage-point acceleration in the growth of labor productivity from
1973-95 (1.4 percent) to 1995-99 (2.4 percent). These studies use a
production-function framework to estimate the contribution of the
change in labor productivity growth stemming from (i) capital deepening, (ii) labor quality, and (iii) total factor productivity. Three of the five
studies found that the dominant contribution arose from an acceleration in total factor productivity growth that was largely due to IT-related
effects.

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Figure 4
Nasdaq and Wilshire 5000 Equity Market Indices
Index, December 1994 = 1
7

6
Nasdaq
5

3
Wilshire 5000
2

0
1990

1993

1996

capital) relative to the Wilshire 5000 index is consistent with the figures reported in Table 1, which
show that the acceleration in BFI was the largest in
the IPES segment.
Beginning in March 2000, markets began to
reassess their estimates of future profitability in the
IT sector. This is seen by the steep decline in the
Nasdaq composite index in Figure 4. By September
10, 2001, the Nasdaq had fallen to just under 1,700,
giving up most of the gains seen over the past three
years. As the equity cost of capital in the IT sector
began to rise sharply, demand for high-tech goods
began to wane. Accordingly, manufacturers of hightech capital goods began to scale back production:
From October 2000 to September 2001, output of
IT capital goods fell 16 percent. And since (nominal)
investment in business E&S had risen to about 10
percent of GDP in 2000, the subsequent fall in the
demand for these products led to a sharp deceleration in output growth (see Table 1).
As seen in Figure 5, the Nasdaq composite
index peaked much earlier (March 2000) than did
production of high-tech capital spending (December
2000), though the growth of high-tech output began
to decelerate markedly in May. Although the timing
suggests that the plunge in the Nasdaq may have
been a significant factor behind the high-tech investment bust, it does not readily explain the decline
36

J A N UA RY / F E B R UA RY 2 0 0 3

1999

2002

in non-high-tech investment spending.10 Although
the Wilshire 5000 index also peaked in March 2000,
real BFI in transportation equipment peaked much
earlier, in the third quarter of 1999, while real fixed
investment in structures peaked in the fourth quarter
of 2000 and industrial equipment during the first
quarter of 2001.
McCarthy (2001) attempted to ascertain whether
falling equity prices could explain the investment
boom and bust in E&S (a mix of high-tech and nonhigh-tech capital goods). To test this hypothesis,
McCarthy used a series of one-step-ahead forecasts
(from the first quarter of 1995 to the second quarter
of 2001) derived from a standard neoclassical model
of business investment, which was augmented with
a measure of equity market valuation (Tobin’s Q).
He found that the model did a reasonably good job
of predicting the growth of real E&S fixed investment
spending from 1995 into early 2000.11 Beginning
in mid-2000, though, the model substantially underpredicted the falloff in capital spending. Using a
counterfactual exercise that assumed equity values
grew from 1995 onward at their 1980-94 pace, he
10

Moreover, recall from the discussion of Table 2 that the largest percentage deviation of IPES investment from trend occurred in the second
quarter of 2000.

McCarthy’s estimates were derived prior to the July 2002 annual NIPA
revisions.

Kliesen

FEDERAL RESERVE BANK OF ST. LOUIS

Figure 5
Nasdaq Composite Index and Output of Selected High-Tech Industries
Index, 2/5/71 = 100
6,000

Index, 1992 = 100
1,400
High-Tech Output
(Right Scale)
1,200

5,000

1,000
4,000
800
3,000
Nasdaq
(Left Scale)

2,000

600
400

1,000

200
0

0
Jan Jul Jan Jul
90 90 91 91

Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul
92 92 93 93 94 94 95 95 96 96

found that the model predicted E&S investment
would have still grown at a double-digit pace, but
that the drop in equity prices exerted some drag on
fixed investment growth. In particular, he found
that real E&S investment growth would have been
about 4 percentage points higher if the stock market
had not fallen as it did.12 Furthermore, McCarthy
found a larger effect from the sharp drop in equipment prices over the latter half of the 1990s, which
he attributes to weak demand. If so, then one potential source of weak demand may have been the end
of the expenditures by businesses to fix the so-called
Y2K computer bug.

CAN Y2K EXPLAIN THE INVESTMENT
BOOM AND BUST?
One explanation of the high-tech investment
boom and bust that has received relatively scant
attention centers on the surge in spending by private
businesses to ready themselves for Y2K.13 The “Y2K
problem,” as it was called, was viewed by some
government entities as “potentially extremely seri12

McCarthy also ran a counterfactual exercise that assumed relative
prices of E&S capital goods from 1995 onward fell at a constant rate
equal to their 1980-94 average. In this counterfactual forecasting
exercise, he found that the model does a better job of forecasting the
investment bust in 2000-01.
The 2002 Economic Report of the President states on p. 36 that some
of the 2000-01 slowdown reflected the “lingering effects” of Y2K.

Jan Jul Jan Jul
97 97 98 98

Jan Jul Jan Jul Jan Jul Jan Jul
99 99 00 00 01 01 02 02

ous,” given the computer’s predominant role in
large industrialized economies.14 According to
industry figures cited by the U.S. Department of
Commerce in July 1998, almost 90 percent of all
firms with fewer than 2,000 employees had not
started Y2K “remediation projects” as of 1997. Moreover, nearly half of all personal computers shipped
in 1997 were not Y2K compliant.15 Some economists
went so far as to predict a “severe” global recession,
arising from widespread disruptions to, for example,
the air transportation system, electrical grids, the
financial infrastructure, and government services.16
To prevent these disturbances from materializing,
the private sector began to devote a considerable
amount of resources to fixing the problem. One
manifestation of this was the upsurge in payroll
employment in computer and data processing services. As seen in Figure 6, year-over-year growth
throughout much of 1999 was quite strong, reaching
nearly 17 percent in August. This rapid growth, however, was not historically large, as evidenced by the
much stronger growth seen during the late 1970s
and early 1980s.
Public policymakers were also devoting con14

Council of Economic Advisers (1999, p. 77).

Bachula (1998).

Edward Yardeni, now at Prudential Securities, was the chief alarmist
on the Y2K issue. See Matthews (1998).

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Figure 6
Employment Growth in Computer and
Data Processing Services
Percent Change, Year Earlier
24
18
12
6
0
–6
1972

1977

1982

1987

1992

1997

2002

SOURCE: U.S. Bureau of Labor Statistics.

siderable time and resources to minimizing the Y2K
problem. The Federal Reserve System, anticipating
a precautionary surge in the demand for cash by
households, formulated a “temporary financing
facility” designed to ensure that sufficient liquidity
existed for the banking system around the time of
the century date change. Part of this effort included
a large increase in the supply of currency to depository institutions.17
Perhaps because of the preventative efforts
undertaken by the public and private sector beforehand, most forecasters evidently were of the opinion
that the Y2K problem would not be a significant
macroeconomic event. Still, some precautionary
spending was expected to occur. According to the
panel of Blue Chip forecasters in July 1999, real GDP
growth in the second half of 1999 was expected to
be boosted by a buildup of business inventories by
firms and an upswing in purchases of nondurable
goods by households. This effect was expected to
be relatively small, though: In the May 1999 Survey
of Professional Forecasters, nearly 60 percent of
forecasters expected the assorted Y2K effects to
boost real GDP growth by 0.1 to 0.5 percentage
points in 1999. In 2000, as these temporary effects
reversed, about half of the forecasters expected an
effect on real GDP growth of between 0.0 and –0.4
17

See the minutes of the August 24, 1999, meeting of the Federal
Open Market Committee (<www.federalreserve.gov/fomc/minutes/
19990824.htm>). From the week ending December 1, 1999, to the
week ending February 2, 2000, surplus vault cash jumped from
$17.4 billion to $40.5 billion. As a share of total vault cash, surplus
cash surged to an all-time high of just over 50 percent.

J A N UA RY / F E B R UA RY 2 0 0 3

percentage points. The net effect was expected to
be essentially zero, and, at first glance, the end-ofyear Y2K disruptions to the aggregate economy
turned out to be minimal.
The alarmists turned out to be wrong about a
Y2K-inspired worldwide depression; nevertheless,
the high-tech investment boom and bust shortly
before and after the century date change suggests
some causality. Table 3, which replicates the HodrickPrescott framework of Table 2, indicates that the
investment bust—as seen by the largest negative
percentage deviation from trend (low)—was especially large for IPES. During the 2001 recession, IPES
investment at one point was 13.68 percent below
trend, which was surpassed only by the severe
1981-82 recession. The average deviation of IPES
investment during the 2001 recession (–7.22 percent),
however, was much larger than in the previous recessions listed. Table 3 also shows (compared with
previous recessions) a large negative deviation for
transportation equipment (–10.5 percent), but not
for industrial equipment (–2.95 percent) or residential fixed investment (–1.88 percent).
The evidence in Table 2 shows that the largest
positive deviation in real IPES investment spending
from trend during the 1991-2001 expansion was not
unusually large (compared with previous expansions). This finding suggests that Y2K spending was
probably not that significant during the investment
boom. However, the evidence from Table 3 is at least
consistent with the conjecture that a cessation of
business spending on Y2K fixes may have exacerbated the sharp decline in IT investment spending.
To see whether the end of Y2K was responsible for
the high-tech investment bust, it will be useful to
look at the estimated amount of Y2K outlays by
businesses that flowed into the NIPA.

Accounting Issues: How Does Y2K
Spending Map into the NIPA?
Given the remediation efforts noted above, it
seems probable that firms replaced a significant
amount of their stock of computers and software,
and spent a considerable amount of resources to
fix existing source code, in an effort to avoid disruptions at the century date change. To see how difficult
estimating the direct result of Y2K-related spending
in the NIPA is, consider three different scenarios by
which Firm A could have undertaken its Y2K fix.
Scenario 1. In the first scenario, suppose
that Firm A paid Firm B $10 million to make its

Kliesen

FEDERAL RESERVE BANK OF ST. LOUIS

Table 3
Where Was the Investment Bust During the 2001 Recession? (Percentage Deviations from Trend)
Recession period

Business
structures

IPES

Industrial
equipment

Transportation
equipment

Residential

1960:Q2 to 1961:Q1
Average deviation

1.90

3.83

2.53

–4.22

–6.44

High

3.55

7.88

11.74

5.35

–2.28

Low

0.67

–3.60

–7.35

–16.14

–8.76

High – Low

2.88

11.48

19.08

21.48

6.48

0.54

4.11

1.28

–12.16

–14.46

1969:Q4 to 1970:Q4
Average deviation
High

2.47

7.92

3.68

1.44

–8.64

Low

–1.29

–0.80

–2.58

–32.48

–22.36

3.76

8.72

6.26

33.92

13.72

High – Low
1973:Q4 to 1975:Q1
Average deviation

3.97

7.18

8.73

–0.24

–12.82

High

7.92

9.29

13.25

12.73

5.32

Low

–3.54

3.21

–3.33

–18.53

–35.85

High – Low

11.46

6.09

16.59

31.26

41.17

3.93

–3.92

–1.96

–14.43

–30.22

1981:Q3 to 1982:Q4
Average deviation
High

11.60

2.55

3.49

–2.99

–13.44

Low

–4.24

–15.29

–10.70

–27.08

–40.88

High – Low

15.83

17.84

14.19

24.08

27.44

Average deviation

5.35

–0.95

–1.58

0.14

–13.33

High

8.20

0.14

1.53

2.78

–5.76

Low

3.26

–3.07

–4.03

–1.41

–20.73

High – Low

4.94

3.21

5.56

4.20

14.97

–2.52

–7.22

–2.95

–10.50

–1.88

1990:Q3 to 1991:Q1

2001:Q1 to 2001:Q4
Average deviation
High
Low
High – Low

2.06

1.66

4.92

–7.57

–0.52

–10.76

–13.68

–9.92

–13.08

–3.63

12.82

15.34

14.84

5.50

3.11

NOTE: Percentages are calculated as deviations from trend in chain-weighted dollars. The trend value is estimated from the HodrickPrescott algorithm. See footnote 5. Sample period for Hodrick-Prescott calculations are 1947:Q1 to 2001:Q4 for all categories except
IPES, which begins in 1959:Q1.

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mainframe computer code Y2K compliant. Bureau
of Economic Analysis methodology stipulates that
“software-related expenditures treated as investment
exclude maintenance and repair expenditures on
existing software, including expenditures to fix
so-called ‘Y2K’ problems.” Accordingly, if Firm A
reports these receipts as software maintenance
and repair, then there would be no corresponding
increase in software investment. However, if Firm
A reports these receipts as custom programming
services (custom software), then the effect is an
increase in software investment.18
Scenario 2. The same rationale holds if, instead
of contracting out the services in question, the firm
decided to hire additional workers for the task
(own-account software). In either case, though,
the $10 million in wages and salaries paid to the
employees would show up on the income side of
the NIPA. Thus, whether the $10 million shows up
as a final output on the product side or is treated
as an intermediate expense on the product side,
depends on how these receipts are reported.19
Scenario 3. Finally, assume instead that Firm A
decided to purchase new software (prepackaged
software) or new Y2K-compliant computers that
included embedded software. In this case, the new
equipment or software would be classified as new
investment even if the equipment or software it
replaced was fully depreciated. Fully ascertaining
what is a final product and what is an intermediate
expense is probably not possible because of data
limitations. That is, U.S. statistical agencies such
as the Bureau of Economic Analysis and the Bureau
of the Census have not published estimates of Y2Krelated spending. There are estimates, however, that
have been pieced together with the help of private
consultants. For example, the U.S. Department of
Commerce’s Economics and Statistics Administration, with the assistance of the International Data
Corporation, reported that nearly half (46 percent)
of worldwide Y2K spending reflected “internal”
efforts to “identify and diagnose the problem, espe18

In the NIPA, there are three types of software treated as a fixed investment: prepackaged, custom, and own-account. See Bureau of Economic
Analysis (2000). In non-benchmark years, investment for prepackaged
and custom software are extrapolated using industry receipts rather
than product-type receipts. For example, the Bureau of Economic
Analysis uses services receipts for a firm that classifies itself as a
custom software establishment to extrapolate (using the input-output
accounts) the NIPA output for custom software. The last input-output
benchmark is for 1992.
In the NIPA, it is assumed that intermediate expenses eventually
show up in final output.

J A N UA RY / F E B R UA RY 2 0 0 3

cially in the case of embedded chips.”20 This fraction is only a little more than a quarter (27 percent)
of total reflected “external” spending. Expenditures
on hardware (11 percent) and software (17 percent)
were also a little more than a quarter of the total
spending. Assuming that these percentages apply
to the United States and that they accurately reflect
the distribution of spending, then only about half
of total Y2K expenditures probably flowed into
the output of final goods and services, with the
remainder slotted as intermediate expenses.21

Y2K Cost Estimates
In testimony before the U.S. Senate Committee
on Commerce, Science, and Transportation, (then)
Federal Reserve Governor Edward Kelley noted that
a survey of corporate 10-K financial reports filed
with the Securities and Exchange Commission by
Federal Reserve Board staff economists indicated
that “an educated guess of the sunk cost of Y2K
remedial efforts in the U.S. private sector might be
roughly $50 billion.”22 The aforementioned Economics and Statistics Administration report, citing
the study commissioned by the International Data
Corporation in October 1999, estimated that the
cost of public- and private-sector Y2K spending in
the United States from 1995 to 2001 was expected
to total $114 billion.23 In inflation-adjusted terms,
as Table 4 indicates, this amounted to roughly $131
billion.
If the numbers in Table 4 are a reasonable
approximation of the actual Y2K-related spending
that occurred, then the efforts of U.S. firms to ready
themselves for the century date change totaled a
bit less than 1.5 percent of GDP over this six-year
period. While fairly significant, it hardly seems to
have been a major event expenditure-wise, given
that it was spread out over several years. Second, if,
as conjectured above, only about half of Y2K expenditures flowed into final output, then the potential
Y2K-related investment contribution to real GDP
20

See Economic and Statistical Administration (1999, pp. 3-4).

A further complication is that, unlike the estimates of prepackaged
and custom software investment described in footnote 18 (commodity flow method), own-account software investment is measured as
the sum of production costs (wage and non-wage) and the costs of
intermediate inputs. See Bureau of Economic Analysis (2000).

<www.federalreserve.gov/boarddocs/testimony/1998/19980428.htm>.

The Economic and Statistical Administration admitted that this estimate was not precise. Accordingly, they place a confidence interval
of $50 billion around either side of their point estimate.

Kliesen

FEDERAL RESERVE BANK OF ST. LOUIS

Table 4
Real Y2K Spending and the Change in Real Fixed Investment in Information Processing
Equipment and Software
Percentage points
Billions of dollars

Percent

IPES
Potential Y2K
contribution to
contribution to
real GDP growth real GDP growth

Year

Y2K

IPES

Y2K/IPES

IPES/GDP

1995

4.3

36.2

11.8

3.5

0.56

0.07

1996

15.5

44.5

34.8

3.7

0.62

0.22

1997

29.4

62.5

47.0

3.9

0.77

0.36

1998

37.7

79.5

47.4

4.1

0.85

0.40

1999

36.5

78.8

46.3

4.3

0.73

0.34

2000

6.8

75.2

9.0

4.5

0.63

0.06

2001

0.8

–34.8

–2.3

4.0

–0.26

0.01

130.9

341.9

N/A

3.90

1.45

Sum: 1995-2001

NOTE: Estimates for 1999-2001 are projections. Real Y2K spending is the current-dollar value of spending deflated by the chain-type
price index for IPES. Sums subject to rounding.
SOURCE: Economics and Statistics Administration, Bureau of Economic Analysis, Haver Analytics, and the author’s calculations (final
column).

growth was much less, about 0.75 percentage points
(half of 1.45 percent). Finally, the bulk of the Y2Krelated spending occurred from 1997 to 1999 ($103.6
billion). Accordingly, the timing of the expenditures
suggests that the surge in IPES investment that
peaked in the fourth quarter of 2000 was probably
not driven by Y2K expenditures. Thus, while the
investment boom and bust was probably exacerbated by Y2K remediation efforts (and their subsequent cessation), it was more likely the result of
declines in the equity cost of capital or other business cycle effects.24 This conclusion is similar to
that reached by the Bank of England, which reported
that in March 2000 only “a small minority of companies were planning much lower IT investment
over the next two years than in the previous two
years.”25

investment boom and bust. Several explanations
have been offered for this development, including
the acceleration in labor productivity—the so-called
“New Economy” story—and the stock market surge
and subsequent collapse. One explanation that has
not been scrutinized in detail was the spending by
businesses to ready themselves for the century date
change. Because many information processing
systems and much of the hardware and software
were not Y2K compliant as late as early 1998, it
was thought that business investment in high-tech
E&S would increase appreciably to fix this problem—
hence, leading to a Y2K-related investment boom
in the late 1990s. Although solid data are lacking,
the evidence presented in this paper indicates that
the investment boom and bust was more than a
Y2K event.

CONCLUSION

REFERENCES

A salient feature of the business cycle that
spanned from March 1991 to the end of 2002 (the
National Bureau of Economic Research Committee
has yet to identify the trough) was the high-tech
24

Macroeconomic Advisers (2002) found “weak evidence” of a Y2K
boost to real software investment.

Bakhshi and Thompson (2002).

Bachula, Gary R. “The Year 2000 (Y2K) Computer Problem.”
Forum on the Year 2000 Y2K Computer Problem, hosted
by Senator Olympia Snowe, 31 July 1998.
<www.ta.doc.gov/speeches/y2k.htm>.
Bakhshi, Hasan and Thompson, Jamie. “Explaining Trends
in UK Business Investment.” Bank of England Quarterly
Bulletin, Spring 2002, 42(1), pp. 33-41.

J A N UA RY / F E B R UA RY 2 0 0 3

Kliesen

Bureau of Economic Analysis. “Recognition of Business and
Government Expenditures for Software as Investment:
Methodology and Quantitative Impacts, 1959-98.”
Unpublished manuscript, May 2000. <www.bea.gov/
bea/papers/software.pdf>.
Council of Economic Advisers. Economic Report of the
President, Washington, DC: U.S. Government Printing
Office, February 1999 and February 2002.
Economics and Statistics Administration, United States
Department of Commerce. “The Economics of Y2K and
the Impact on the United States.” 17 November 1999.
French, Eric; Klier, Thomas and Oppedahl, David. “Is There
Still an Investment Overhang, and If So, Should We Worry
About It?” Federal Reserve Bank of Chicago Fed Letter,
May 2002.
Greenspan, Alan. Testimony before the Committee on
Banking, Housing, and Urban Affairs, U.S. Senate. Board
of Governors of the Federal Reserve System, 21 July 1998.
Macroeconomic Advisers. Economic Outlook. 20 May 2002
and 21 June 2002.
Matthews, Gordon. “Deutsche Bank Economist Sees 70%
Chance Year-2000 Glitch Will Cause Severe Recession.”
American Banker, 6 July 1998, pp. 33-34.
McCarthy, Jonathan. “Equipment Expenditures Since 1995:
The Boom and the Bust.” Federal Reserve Bank of New
York Current Issues in Economics and Finance, October
2001, 7(9), pp. 1-6.
Pakko, Michael R. “The High-Tech Investment Boom and
Economic Growth in the 1990s: Accounting for Quality,”
Federal Reserve Bank of St. Louis Review, March/April
2002, 84(2), pp. 3-18.
Stiroh, Kevin J. “Information Technology and the U.S.
Productivity Revival: A Review of the Evidence.” National
Association for Business Economics Business Economics,
January 2002, 37(1), pp. 30-37.
Whelan, Karl. “A Guide to the Use of Chain Aggregated NIPA
Data.” Working Paper 2000-35, Finance and Economics
Discussion Series, Federal Reserve Board of Governors,
June 2000.

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The Financial Condition of U.S. Banks:
How Different Are Community Banks?
R. Alton Gilbert and Gregory E. Sierra
his article examines the condition of U.S.
commercial banks of various sizes since the
early 1990s, with an emphasis on differences
between the condition of community banks and
larger banks. There is evidence that deterioration
in the condition of banks has adverse effects on
the pace of economic activity. One reason for examining the condition of banks of different size, rather
than the condition of the entire banking industry,
is that community banks account for a disproportionate share of bank loans to small businesses. In
addition, failures of community banks account for
a disproportionate share of losses to the deposit
insurance funds.
Despite the consolidation of the banking industry in recent years, community banks continue to
constitute a relevant portion of the banking industry.
We identify community banks as those with less
than $1 billion in assets.1 As of the fourth quarter
of 2001, 85 percent of all banks had total assets less
than $1 billion. While community banks accounted
for about 15 percent of banking assets in the second
quarter of 2001, they held about 40 percent of the
number of business loans outstanding of less than
$1 million.2 Furthermore, there is evidence that the
failure of community banks can have adverse effects
on local economic activity.3 The condition of com-

It is common to identify community banks in terms of the amount
of their assets. For instance, the Gramm-Leach-Bliley Act of 1999
identifies community financial institutions (banks and savings and
loan associations) as those with total assets of less than $500 million.
American Banker uses a definition of a community bank that includes
total assets of $1 billion; see p. 6 of the March 27, 2002, issue. In a
discussion of the condition of community banks, Governor Susan Bies
of the Federal Reserve Board refers to data for banks with total assets
less than $1 billion (Bies, 2002).

See Berger, Demsetz, and Strahan (1999) for a survey of the literature
on the effects of consolidation of the banking industry, including the
role of small banks in lending to small businesses.

See Gilbert and Kochin (1989). For a study that draws the opposite
conclusion from data for Texas, see Clair, O’Driscoll, and Yeats (1994).
R. Alton Gilbert is a vice president and banking advisor and Gregory E.
Sierra is an associate economist at the Federal Reserve Bank of St.
Louis. The authors thank Bill Emmons, Tom King, Andy Meyer, Tim
Yeager, and David Wheelock for their comments.

munity banks is especially relevant for an assessment
of the risk of loss by the deposit insurance fund, since
bank failure rates and Federal Deposit Insurance
Corporation (FDIC) loss rates on bank failures have
been inversely related to bank size (Shibut, 2001).
As the data presented in Tables 1 through 7 in
this article are quickly out of date, see the web site
of the Research Division of the Federal Reserve Bank
of St. Louis for the most current data. In the past
the condition of banks has varied substantially
among regions of the United States (FDIC, 1997).
Although the tables in this article are not presented
by geographic region, the data appendix on the web
site includes current data on the measures of bank
condition in the nine U.S. Census divisions.

WHY IS THE CONDITION OF THE
BANKING INDUSTRY IMPORTANT?
Before examining indicators of the condition
of the banking industry, we discuss the evidence
that this information may be relevant for the performance of the economy. Lown, Morgan, and Rohatgi
(2000) examine how changes in the credit standards
of banks have affected the growth of bank loans and
the pace of economic activity. Their evidence is based
on a survey of changes in the standards that relatively large banks apply in their lending decisions.4
Lending standards include collateral requirements
and the minimum credit rating and maximum
leverage requirements of borrowers. Lown, Morgan,
and Rohatgi (2000) present evidence that changes
in the percentage of banks that report tightening
their credit standards for commercial and industrial
(C&I) lending affect the growth rate of bank lending
and some measures of economic activity. If deterioration in the financial condition of banks induces
them to tighten their lending standards, then adverse
effects on the pace of economic activity could result.
However, this possible result cannot be inferred for
community banks because all of the banks included
4

The sample of banks for the Senior Loan Officers Opinion Survey on
Bank Lending Practices is selected from among the largest banks in
each Federal Reserve District. As of 2001, large banks are identified
as those with total domestic assets of $20 billion or more.

J A N UA RY / F E B R UA RY 2 0 0 3

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Gilbert and Sierra

in that terms of lending survey are substantially
larger than community banks.
The period of the 1980s and early 1990s is especially important for an analysis of the effects of
bank condition on the performance of the economy.
Several hundred banks failed during these years,
and many of the banks were subject to close supervision during at least part of this period. Supervisors
usually require banks with substantial loan problems
to increase their capital ratios, and these banks
often attempt to increase their capital ratios by
reducing their assets (Peek and Rosengren, 1995b
and 1996; Curry et al., 1999).
Several studies report evidence of a credit
crunch in the 1980s and early 1990s. In a credit
crunch, large numbers of banks simultaneously
restrict their lending. An increase in problem loans
may induce banks to restrict their lending. Some
bank customers who are denied credit do not have
access to credit from alternative sources on terms
similar to those provided to them in the past. In a
credit crunch, the decline in the supply of bank loans
is large enough to reduce the pace of economic
activity. Studies in the credit crunch literature draw
different conclusions about the magnitude of the
effect of the credit crunch on the pace of economic
activity (Berger and Udell, 1994; Bernanke and Lown,
1991; Hancock, Laing, and Wilcox, 1995; and Peek
and Rosengren, 1995a).
How relevant the evidence from the credit crunch
period is for other periods depends on what caused
banks to reduce the supply of credit. If banks reduced
lending because of the deterioration in their condition, we may conclude that a similar deterioration in
their condition in the future would induce a similar
restriction on bank lending. One of the charges by
bankers during that period, however, was that bank
supervisors had tightened standards for judging a
bank to be in satisfactory condition, forcing many
banks to reduce their lending. If that charge is correct, the evidence of the credit crunch period would
not be relevant for considering how a deterioration
in the condition of banks would affect the supply
of loans. Berger et al. (2001) recently reexamined
the credit crunch episode to determine whether
there was evidence of a tightening of supervisory
standards. They find evidence that the toughness
of supervisory standards for satisfactory banking
condition increased during the credit crunch period
(1989-92) and declined during the following boom
period in bank lending (1993-98). They conclude,
however, that these changes in supervisory stan44

J A N UA RY / F E B R UA RY 2 0 0 3

dards had only small effects on bank lending. The
implication of Berger et al. (2001) is that the reduction in the supply of bank credit during the credit
crunch period reflected primarily the deterioration
in the condition of banks rather than a tightening
of supervisory standards.
The studies cited in this section do not attempt
to isolate the effects of the condition of community
banks on the pace of economic activity. Although
several of the studies of the credit crunch include
data for small banks (Bernanke and Lown, 1991;
Berger and Udell, 1994; and Berger, Kyle, and Scalise,
2001), the authors do not attempt to attribute the
effects on real economic activity to restrictions in
the supply of credit by small banks. An argument
that deterioration in the condition of community
banks has adverse effects on real economic activity
must be based on the role of community banks in
lending to small businesses, which tend to have
fewer borrowing options than larger businesses,
and the possible adverse effects of individual bank
failures on economic activity in the communities
where the failed banks had offices.

TRENDS IN THE CONDITION OF BANKS
Table 1 presents the number of banks in each
size group in each period. The largest changes over
time involve the banks in the smallest and largest
size groups. Since 1991 there has been a large reduction in the number of banks with total assets less
than $300 million, and the number of banks in the
largest group (total assets in excess of $20 billion)
more than doubled. These changes reflect consolidation of the banking industry and internal growth
of banks, which, in many cases, moved banks into
the larger size groups.
Tables 2 through 7 present trends in the condition of banks in various size groups since 1991. Each
bank is assigned to one of the five size groups each
quarter based on its total assets that quarter. The
five size groups are not indexed over time for inflation; the minimum and maximum asset size for the
banks in each group in these tables remain fixed
over time. One reason for using size groups fixed
in nominal dollars is that the banks with assets below
$300 million are subject to different reporting
requirements than larger banks.

Nonperforming Loans
Table 2 presents our first measure of problem
loans: the percentage of total loans that are non-

Gilbert and Sierra

FEDERAL RESERVE BANK OF ST. LOUIS

Table 1
Number of Banks by Asset Class and Date
Total assets of banks (millions of dollars)
Period

Up to $300

$300 to $1,000

$1,000 to $10,000

$10,000 to $20,000

Over $20,000

1991

10,980

631

321

1992

10,525

635

324

1993

10,055

630

320

1994

9,558

637

326

1995

8,988

644

334

1996

8,536

658

331

1997

8,171

675

306

1998

7,797

692

309

1999:Q1

7,604

675

313

1999:Q2

7,549

684

311

1999:Q3

7,480

702

308

1999:Q4

7,401

737

309

2000:Q1

7,361

728

292

2000:Q2

7,309

736

291

2000:Q3

7,203

736

295

2000:Q4

7,118

748

307

2001:Q1

7,022

771

305

2001:Q2

6,947

786

306

2001:Q3

6,889

811

312

2001:Q4

6,798

835

312

NOTE: The number of banks in each size class by date includes all banks with total assets (call report item rcfd2170) greater than zero.
For annual observations, the number of banks equals the average number of the prior four quarters. Size class is determined on a
quarterly basis.

performing. Nonperforming loans are those loans
that bank managers report as past due 90 days or
more or classify as nonaccrual. Banks stop accruing
interest due on loans as current income when they
classify the loans as nonaccrual.
Nonperforming loan ratios of community banks
(the first two columns of Table 2) increased modestly
during 2001. In contrast, the nonperforming loan
ratios of banks with total assets in excess of $10
billion began rising during the late 1990s and during
2001 rose substantially above the average nonperforming loan ratios of community banks. For banks
in each size group, however, nonperforming loan
ratios in recent quarters remain far below the
nonperforming loan ratios for banks of comparable size during 1991, the last year of the 1990-91
recession.

Charge-Off of Loan Losses
The trend and level of loan charge-offs can also
help in the assessment of asset quality. A high level
of charge-offs, per se, does not indicate a weak portfolio because the charged-off assets are no longer
on the books. However, recent charge-offs can be
informative about the assets that remain on the
books because the remaining assets may have been
originated under similar circumstances or at about
the same time. Table 3 presents the net charge-off
rate for total loans.
In interpreting the patterns in Table 3, it is important to recognize seasonal patterns in charge-off
rates. Among the banks in each group with total
assets less than $10 billion, charge-off rates rose
from the third quarter to the fourth quarter in each
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Gilbert and Sierra

Table 2
Percentage of Total Loans That Are Nonperforming
Total assets of banks (millions of dollars)
Period

Up to $300

$300 to $1,000

$1,000 to $10,000

$10,000 to $20,000

Over $20,000

1991

2.03

2.42

3.27

3.92

5.67

1992

1.63

1.92

2.55

3.13

4.80

1993

1.35

1.54

1.79

1.76

2.70

1994

1.07

1.05

1.12

1.32

1.61

1995

1.03

0.99

1.06

1.12

1.35

1996

1.00

0.96

1.14

1.00

1.01

1997

0.92

0.84

1.07

1.12

0.91

1998

0.94

0.80

1.03

1.10

0.94

1999:Q1

0.98

0.82

0.99

1.19

0.98

1999:Q2

0.95

0.75

0.88

1.28

0.93

1999:Q3

0.93

0.78

0.87

1.31

0.99

1999:Q4

0.82

0.72

0.82

1.16

1.00

2000:Q1

0.87

0.73

0.85

1.14

1.01

2000:Q2

0.86

0.71

0.82

1.17

1.05

2000:Q3

0.86

0.77

0.85

1.22

1.09

2000:Q4

0.85

0.77

0.90

1.31

1.24

2001:Q1

0.92

0.82

1.00

1.31

1.32

2001:Q2

0.98

0.86

1.02

1.28

1.40

2001:Q3

1.03

0.92

1.09

1.43

1.48

2001:Q4

1.01

0.91

1.03

1.35

1.62

NOTE: Percentage of nonperforming loans equals total nonperforming loans divided by total loans. Nonperforming loans are those
loans that bank managers classify as 90 days or more past due or nonaccrual in the call report. Precisely, total nonperforming loans
equals the sum of call report items rcfd1403 and rcfd1407. Total loans equals call report item number rcfd2122. When an annual number
alone is given, it is the mean of quarterly numbers. Bank size group is determined on a quarterly basis.

of the years 1999 through 2001. For the banks in
these size categories, therefore, it is more appropriate
to compare the charge-off rates in the fourth quarter
of 2001 with the rates in the fourth quarter of 2000
rather than compare them with the charge-off rates
in the third quarter of 2001.
Net charge-off rates rose slightly among community banks during 2001. The net charge-off rates
among banks with total assets above $1 billion, in
contrast, began to rise during the 1990s and have
risen during recent quarters to levels substantially
above those for community banks. Charge-off
rates among banks in each size group remain below
1991 levels. Although the weakness in the economy
has been accompanied by increasing net charge-offs
and asset quality recently has fallen only slightly,
46

J A N UA RY / F E B R UA RY 2 0 0 3

the recent upward trend in charge-offs has not yet
reversed.
One challenge in interpreting changes in net
charge-off rates over time is that these changes may
reflect to some extent changes over time in supervisory standards. Supervisors have the authority to
influence the magnitude and timing of charge-offs
of loan losses by banks. Berger et al. (2001) find some
evidence of changes in supervisory standards over
time, but these changes in standards had only a
small effect on bank lending.

Problem Commercial and Industrial
Loans
Losses on C&I loans are often important causes
of serious financial problems in banks. Tables 4 and

Gilbert and Sierra

FEDERAL RESERVE BANK OF ST. LOUIS

Table 3
Percentage of Total Loans Charged Off as Losses
Total assets of banks (millions of dollars)
Period

Up to $300

$300 to $1,000

$1,000 to $10,000

$10,000 to $20,000

Over $20,000

1991

1.14

1.52

2.04

1.93

2.28

1992

0.83

1.18

1.57

1.50

1.65

1993

0.54

0.72

0.93

1.01

1.09

1994

0.41

0.47

0.62

0.79

0.45

1995

0.42

0.53

0.91

0.82

0.39

1996

0.43

0.63

1.00

0.95

0.35

1997

0.41

0.50

1.22

1.27

0.52

1998

0.46

0.60

1.13

1.01

0.63

1999:Q1

0.22

0.38

0.83

0.96

0.57

1999:Q2

0.27

0.33

0.72

1.01

0.51

1999:Q3

0.28

0.33

0.68

1.16

0.57

1999:Q4

0.42

0.52

0.78

1.07

0.68

2000:Q1

0.19

0.39

0.64

0.98

0.54

2000:Q2

0.31

0.32

0.52

1.09

0.54

2000:Q3

0.29

0.36

0.61

1.17

0.57

2000:Q4

0.41

0.46

0.79

1.48

0.97

2001:Q1

0.20

0.30

0.67

1.44

0.73

2001:Q2

0.28

0.40

0.87

1.26

0.84

2001:Q3

0.34

0.39

0.89

1.52

1.09

2001:Q4

0.52

0.56

1.40

1.42

1.49

5 present average nonperforming loan ratios and
net charge-off rates for C&I loans. Nonperforming
C&I loan ratios declined substantially during the
economic recovery after the 1990-91 recession
through 1997 for banks in each size group (Table 4).
Trends in the nonperforming C&I loan ratios of
community banks and larger banks diverged after
1997, rising among banks with total assets above
$1 billion but not among community banks. Nonperforming C&I loan ratios rose slightly during 2001
among banks with assets between $300 million and
$1 billion, but continued to decline among banks
in the smallest size group. During 2001, nonperforming C&I loan ratios were lower among community
banks than among larger banks.
The quarterly pattern of net charge-off rates

on C&I loans (Table 5) indicates the tendency for
the banks in each size group to concentrate their
charge-offs in the fourth quarter of the year.
Although charge-off rates on C&I loans rose in recent
quarters among community banks, their charge-off
rates are substantially lower than those for larger
banks.

Coverage and Equity Ratios
The financial health of banks depends not only
on the magnitude of their problem loans (Tables 2
through 5), but also on the capacity of the banks to
absorb loan losses (Tables 6 and 7). Interpretation
of the patterns in Tables 6 and 7 requires information about bank accounting practices for nonperforming loans and for loan losses. When a bank
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Gilbert and Sierra

Table 4
Percentage of Commercial Loans That Are Nonperforming
Total assets of banks (millions of dollars)
Period

Up to $300

$300 to $1,000

$1,000 to $10,000

$10,000 to $20,000

Over $20,000

1991

4.17

3.18

3.74

4.34

5.34

1992

3.61

2.53

2.77

3.58

3.87

1993

2.83

1.89

1.74

1.79

2.10

1994

2.24

1.20

0.98

1.19

1.23

1995

2.07

1.10

0.98

1.19

1996

2.07

1.24

0.90

0.72

0.86

1997

1.95

1.12

0.83

0.61

0.73

1998

2.06

1.15

0.90

0.83

0.89

1999:Q1

2.27

1.16

1.01

0.97

1.00

1999:Q2

2.19

1.06

1.00

1.28

0.99

1999:Q3

2.13

1.20

1.07

1.14

1.15

1999:Q4

1.79

1.05

0.91

1.18

1.17

2000:Q1

1.92

1.09

1.04

1.21

1.27

2000:Q2

1.90

1.13

1.15

1.30

1.43

2000:Q3

1.91

1.22

1.23

1.35

1.57

2000:Q4

1.78

1.18

1.33

1.56

1.74

2001:Q1

1.40

1.31

1.53

1.64

1.95

2001:Q2

1.47

1.32

1.58

1.65

2.24

2001:Q3

1.54

1.40

1.72

1.90

2.39

2001:Q4

1.46

1.27

1.62

2.02

2.73

NOTE: Percentage of nonperforming commercial loans equals total nonperforming commercial loans divided by total commercial
loans. Nonperforming commercial loans are those commercial loans that bank managers classify as 90 days or more past due or nonaccrual in the call report. Precisely, nonperforming commercial loans equals the sum of call report items rcfd1252, rcfd1253, rcfd1255,
rcfd1256, rcon1223, rcon1224, rcon1607, and rcon1608. Total commercial loans equals call report item number rcfd1766. When an annual
number alone is given, it is the mean of the quarterly numbers. Bank size group is determined on a quarterly basis.

charges off a loan as a loss, it reduces its loans and
reduces an account called the “allowance for loan
and lease losses” by the amount of the loan that
was charged off as a loss. The bank increases the
dollar amount of its allowance for loan and lease
losses by incurring an expense called “provision for
loan and lease losses.” In other words, the allowance
for loan and lease losses represents the accumulation of all provisions for loan and lease losses less
all charge-offs to the account. Since provisions are
expenses, increases in provisions reduce net income.
As with any expense, provisions for loan and lease
losses reduce a bank’s equity.
Under the principles of bank accounting, loans
reported as nonperforming have not yet been
48

J A N UA RY / F E B R UA RY 2 0 0 3

charged off as losses. When a bank charges a nonperforming loan off as a loss, it no longer reports
the loan as nonperforming. An increase in nonperforming loans increases the chances that a bank
will have larger charges against its allowance for
loan and lease losses in the future. Banks often
increase their allowances for loan and lease losses
through larger provisions when they anticipate
future losses on nonperforming loans.
A measure of the adequacy of a bank’s allowance
to absorb future loan losses is the ratio of the allowance to the amount of nonperforming loans, commonly called the “coverage ratio.” An allowance
greater than nonperforming loans suggests that even
if all of a bank’s nonperforming loans were charged

Gilbert and Sierra

FEDERAL RESERVE BANK OF ST. LOUIS

Table 5
Percentage of Commercial Loans Charged Off as Losses
Total assets of banks (millions of dollars)
Period

Up to $300

$300 to $1,000

$1,000 to $10,000

$10,000 to $20,000

Over $20,000

1991

3.13

2.53

2.59

1.97

2.57

1992

2.29

1.97

1.37

1.23

1.17

1993

1.52

0.86

0.90

0.77

0.53

1994

1.16

0.47

0.33

0.26

0.16

1995

1.14

0.70

0.22

0.36

0.26

1996

1.07

0.70

0.40

0.17

0.10

1997

1.05

0.64

0.26

0.41

0.29

1998

1.24

0.75

0.64

0.47

0.56

1999:Q1

0.46

0.31

0.30

0.39

0.46

1999:Q2

0.77

0.23

0.40

0.41

0.55

1999:Q3

0.62

0.36

0.68

0.47

0.60

1999:Q4

1.16

0.79

0.90

0.73

0.72

2000:Q1

0.30

0.31

0.41

0.40

0.55

2000:Q2

0.65

0.46

0.47

0.60

0.69

2000:Q3

0.63

0.44

0.83

0.62

0.69

2000:Q4

1.12

0.88

1.08

1.12

1.33

2001:Q1

0.35

0.36

0.60

0.95

0.99

2001:Q2

0.58

0.69

1.07

0.82

1.29

2001:Q3

0.66

0.81

1.06

1.00

1.59

2001:Q4

1.23

1.10

2.90

1.45

2.69

NOTE: Charge-offs are measured on a net basis—loans charged off as losses minus recoveries on loans previously charged off. The
percentage of loans charged off as losses each quarter (net of recoveries on loans previously charged off as losses) is calculated by
summing net commercial loan charge-offs for all banks in the size group and dividing by the sum of their total commercial loans.
Quarterly percentages are multiplied by four to raise them to annual rates.
Because of changes in the call report in 2001, the charge-off rate on commercial and industrial loans for banks with total assets below
$300 million for 2001 are not exactly comparable to those for previous years. Prior to 2001:Q1, the ratio displayed equals the chargeoff rate for commercial and industrial loans and “other loans.” The numbers in the column “Up to $300” should be comparable before
and after 2001:Q1, however, because in no time period did “other loans” of banks under $300 million exceed 3 percent of the sum of
commercial and industrial and “other loans.” The charge-off rate in 2001 is comparable for banks across size classes.

off as losses, its allowance would be adequate to
absorb the charge-offs. In addition, banks with coverage ratios above unity are less likely to need relatively
large provisions for loan and lease losses in the
future, to offset losses charged against their allowance, than banks with coverage ratios below unity.
Table 6 shows the percentage of assets among
banks with coverage ratios of unity or higher. An
increase in this percentage bolsters the protection
of bank equity from charge-offs of nonperforming
loans. These percentages were relatively low in 1991
but increased rapidly in the following years. During

recent quarters, this percentage has declined for
banks in each size group, with the largest declines
among banks with assets in excess of $20 billion.
As recently as the third quarter of 2000, almost all
of the assets among these large banks were held by
banks with coverage ratios in excess of unity. The
average percentage for 2001, in contrast, was just
above 80 percent.
The coverage ratios for loan losses (shown in
Table 6) have also declined during recent quarters
among community banks, and this measure is lower
for community banks than for larger banks. This
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Gilbert and Sierra

Table 6
Percentage of Assets at Banks Whose Allowance for Loans and Lease Losses Exceeds Their
Nonperforming Loans
Total assets of banks (millions of dollars)
Period

Up to $300

$300 to $1,000

$1,000 to $10,000

$10,000 to $20,000

Over $20,000

1991

55.05

49.74

42.46

31.53

19.48

1992

66.57

64.02

66.07

55.85

34.39

1993

72.34

76.40

81.65

84.33

53.15

1994

77.86

86.16

93.04

91.41

97.80

1995

77.65

84.02

87.53

95.45

94.35

1996

75.87

81.90

89.21

92.10

98.86

1997

77.34

86.04

89.87

87.36

100.00

1998

76.62

86.34

88.40

85.49

97.71

1999:Q1

76.03

86.29

89.55

87.80

97.54

1999:Q2

76.51

86.41

90.59

91.00

98.19

1999:Q3

76.88

86.68

90.35

91.45

97.63

1999:Q4

78.83

88.56

90.50

93.78

96.93

2000:Q1

77.43

86.34

90.62

90.77

98.68

2000:Q2

77.74

87.25

88.19

93.88

98.76

2000:Q3

77.48

84.45

87.28

89.46

98.91

2000:Q4

78.32

84.42

84.16

92.66

92.14

2001:Q1

74.38

82.91

85.14

92.50

83.23

2001:Q2

73.29

81.53

85.15

88.05

79.30

2001:Q3

70.77

78.75

80.83

83.14

76.78

2001:Q4

71.68

78.89

82.83

89.05

82.18

NOTE: Each bank is classified by whether the ratio of its allowance for loan and lease losses to nonperforming loans is greater than
one. The allowance for loan and lease losses is the sum of call report items rcfd3123 and rcfd3128. Total nonperforming loans equals
the sum of call report items rcfd1403 and rcfd1407. For each size category, the sum of total assets held by banks where this ratio is
greater than one is divided by the sum of total assets held by banks in the class.

contrast implies that if the loss rate on nonperforming loans were the same on average among the banks
in each size group, then the allowances for loan
losses would tend to be less adequate to absorb
losses (i.e., to avoid reductions in equity) among
community banks than among larger banks.
The capacity of banks to absorb losses also
depends on the amount of equity those banks hold.
Table 7 indicates that banks in each size group have
maintained relatively high ratios of equity to total
assets during recent quarters. As of the end of 2001,
the equity ratios for banks in each size group were at
or near their highest levels since 1991. The banking
system has substantial equity available to absorb
50

J A N UA RY / F E B R UA RY 2 0 0 3

losses that banks may incur because of large and
unexpected decreases in asset quality.

Assessment of Patterns in Bank
Accounting Information
Overall, the accounting numbers in Tables 2
through 5 indicate that loan quality has diminished
during recent quarters, more so for larger banks than
for community banks. Community banks have maintained lower nonperforming loan and charge-off
ratios than larger banks, although they have slightly
smaller buffers to absorb loan losses than do larger
banks. Yet, the percentage of assets at community
banks with coverage ratios greater than unity is still

Gilbert and Sierra

FEDERAL RESERVE BANK OF ST. LOUIS

Table 7
Total Equity as a Percentage of Total Assets
Total assets of banks (millions of dollars)
Period

Up to $300

$300 to $1,000

$1,000 to $10,000

$10,000 to $20,000

Over $20,000

1991

8.88

7.78

7.29

6.27

5.24

1992

9.22

8.31

8.13

7.41

6.66

1993

9.72

8.88

8.74

8.00

7.37

1994

9.66

9.08

8.55

8.49

6.91

1995

10.60

9.62

9.22

8.53

7.16

1996

10.57

9.81

9.44

8.30

8.10

1997

10.85

10.25

9.95

9.33

8.35

1998

10.89

9.97

10.59

10.23

8.27

1999:Q1

10.36

9.41

9.83

8.87

7.93

1999:Q2

10.32

9.39

9.76

8.32

7.97

1999:Q3

10.39

9.62

9.67

8.74

8.44

1999:Q4

10.30

9.65

9.79

8.48

8.76

2000:Q1

10.04

9.37

9.16

8.58

8.03

2000:Q2

10.28

9.43

8.94

9.32

8.10

2000:Q3

10.57

9.67

9.42

9.50

8.41

2000:Q4

10.86

10.04

9.62

9.58

8.44

2001:Q1

10.55

9.85

9.38

9.45

8.25

2001:Q2

10.68

9.94

9.65

10.18

8.27

2001:Q3

10.94

10.19

9.99

10.64

8.87

2001:Q4

10.82

10.21

10.30

11.13

9.32

NOTE: For banks in each size category, the sum of equity is divided by the sum of total assets. Equity equals call report item rcfd3210,
and total assets is derived from call report item rcfd3368.

high relative to the early 1990s, indicating that community banks have more adequate buffers of allowances for loan losses now than during that time.
Banks in each of the five size groups, on average,
currently have high ratios of equity to total assets
relative to those in the early 1990s—large enough
to absorb substantial losses. In sum, the analysis
based on Tables 2 through 7 suggests that bank
condition has weakened recently but is still good.
Whether the trend of diminishing loan quality continues to undermine the condition of banks hinges
in part upon the performance of the U.S. economy.

SIMULATION OF AN EARLY WARNING
MODEL
Each of the financial ratios in Tables 2 through
7 provides limited information about the condition

of banks, and some of the ratios provide conflicting
signals. For instance, Table 2 shows rising nonperforming loan ratios, whereas Table 7 shows rising
ratios of equity to total assets. Early warning models
provide a means of condensing several measures
of bank condition into an index number that weights
financial ratios by how much each measure contributes to the prediction of a bank’s financial distress. We use the output from the SEER risk-rank
model as a means of condensing several measures
of bank condition into one signal.
The Federal Reserve uses a system for bank
surveillance called the System for Estimating
Examination Ratings (SEER). One of the models
used in this surveillance system is called the SEER
risk-rank model. The SEER risk-rank model estimates
the probability, ranging from 0 to 100 percent, that
J A N UA RY / F E B R UA RY 2 0 0 3

REVIEW

Gilbert and Sierra

Table 8
What Are the SEER Failure-Prediction Variables?
This table lists the independent variables used in the SEER (System to Estimate Examination Ratings) risk-rank model.
The signs indicate the hypothesized relationship between each variable and the likelihood of failure in the next two
years. For example, the negative sign for the net-income (ROA) ratio indicates that an increase in earnings reduces
the likelihood of failure, all other things equal. We use the median of failure probabilities estimated by the SEER
risk-rank model as an index of the overall health of community banks and large banks.
Variable
Credit risk

Leverage risk

Liquidity risk

Control variable

Effect on failure probability

Loans past due 30-90 days/total assets

Loans past due 90+ days/total assets

Nonaccrual loans/total assets

Other real estate owned (OREO)/total assets

Residential real estate loans/total assets

–

Commercial and industrial loans/total assets

Tangible capital/total assets

–

Net income/average assets (ROA)

–

Investment securities/total assets

–

Large time deposits/total assets

Natural log of total assets

–

NOTE: + indicates that higher levels of the variable lead to higher probabilities of failure; – indicates the opposite.
Table adapted from Cole, Cornyn, and Gunther (1995).

a bank will fail within the next two years. The model
uses data from banks that failed during the period
from 1985 to 1991 to provide a statistical relationship between bank failures and financial data. This
relationship is used to estimate a quarterly SEER
risk rank for each bank using current data from the
call report.5 The independent variables of the SEER
risk-rank model (which are described in Table 8)
capture credit risk, leverage risk, liquidity risk, and
size. Although the model’s parameters are derived
from data during the 1985 to 1991 period, the model
is validated annually and has been shown to perform
about as well as other surveillance models whose
parameters are reestimated each period (Gilbert,
Meyer, and Vaughan, 2002). For more details on the
SEER risk-rank model, see Cole, Cornyn, and Gunther
(1995). One can use early warning models to derive
measures of the performance of the banking indus5

The reader can find this description of the SEER risk-rank model and
how it’s used as a regulatory monitoring tool in the Federal Reserve
Commercial Bank Examination Manual.

J A N UA RY / F E B R UA RY 2 0 0 3

try, as we do here (Gilbert, Meyer, and Vaughan,
2001). Since community banks have had different
risk profiles and higher failure rates in the past than
larger banks, we look at each group’s median SEER
risk rank separately.
Figure 1 plots the median failure probability for
two groups of banks: community banks (assets less
than $1billion) and large banks (assets greater than
or equal to $1 billion). The median failure probability
declined in the 1990s for both community banks and
large banks. During more recent years, the median
SEER risk rank of community banks has risen but
stands only about 4 basis points higher than that
of larger banks. The median SEER risk-rank level
of both groups is still far below the level during the
1990-91 recession.

REACTIONS OF SUPERVISORS TO
LOAN QUALITY PROBLEMS
If the dollar amount of problem loans rises high
enough to threaten substantial losses relative to a

Gilbert and Sierra

FEDERAL RESERVE BANK OF ST. LOUIS

Figure 1
Median SEER Risk Rank of U.S. Commerical Banks
Percent
0.6

0.5

0.4
Large Banks
0.3

0.2
Community Banks
0.1

0
Dec
84

Dec
85

Dec
86

Dec
87

Dec
88

Dec
89

Dec
90

Dec
91

Dec
92

Dec
93

Dec
94

Dec
95

Dec
96

Dec
97

Dec
98

Dec
99

Dec
00

Dec
01

NOTE: Community banks are banks with less than $1 billion in total assets, and large banks are banks with assets
greater than or equal to $1 billion. Data are quarterly.

bank’s loan loss reserves and equity, the supervisor
of the bank may downgrade its rating and impose
an enforcement action on the bank. Most enforcement actions are agreements between banks in
unsatisfactory condition and their supervisors about
the actions that are necessary to restore the banks
to satisfactory condition.6
Supervisors identify the banks that warrant
enforcement actions through regularly scheduled
on-site examinations. The Federal Deposit Insurance
Corporation Improvement Act of 1991 requires
supervisors to examine each bank every 12 to 18
months. Supervisors assess six components of bank
condition during these on-site examinations—capital
protection (C), asset quality (A), management competence (M), earnings strength (E), liquidity risk (L),
and sensitivity to market risk (S)—awarding a grade
of 1 (best) through 5 (worst) to each component.
Examiners then use these six scores to award a
composite CAMELS rating, also expressed on a 1
through 5 scale. Table 9 interprets each of the five
6

Some enforcement actions are cease and desist orders of courts that
require bank management to cease actions that threaten the solvency
of the banks. See Gilbert and Vaughan (1998) for information about
enforcement actions.

composite CAMELS ratings. Supervisors give CAMELS
composite scores of 1 or 2 to the banks they consider
to be in satisfactory condition, and they give CAMELS
composite scores of 3, 4, or 5 to unsatisfactory
banks. Supervisors monitor the unsatisfactory banks
closely and discipline them through enforcement
actions. Banks tend to respond to a CAMELS ratings
downgrade to unsatisfactory status and enforcement
actions by reducing the growth rates of their assets
and loans (Peek and Rosengren, 1995a,b and 1996;
and Curry et al., 1999).
The CAMELS rating of a bank at a given point
in time reflects the results of an examination conducted sometime during the prior 18 months. Figure
2 indicates the extent to which examiners identified
problems during exams conducted each quarter
since 1991. For the line labeled “Community Banks,”
the denominator is the number of community banks
that entered the quarter rated as CAMELS 1 or 2
and were subject to examinations begun during
the quarter. The numerator is the number of these
banks that were rated as CAMELS 3, 4, or 5 on the
exams begun during the quarter. This line indicates
the rate at which the community banks initially rated
as being in satisfactory condition were downgraded
J A N UA RY / F E B R UA RY 2 0 0 3

REVIEW

Gilbert and Sierra

Table 9
What Are CAMELS Composite Ratings?
“CAMELS” is an acronym for six components of bank condition—capital protection (C), asset quality (A), management competence (M), earnings strength (E), liquidity risk (L), and sensitivity to market risk (S). Supervisors assign
a grade of 1 (best) through 5 (worst) to each component. They use these six component scores to award a CAMELS
composite rating, also expressed on a 1 through 5 scale. The following is a brief description of the individual CAMELS
composite ratings. Supervisors view a bank with a rating of 1 or 2 as being in satisfactory condition. When it is
downgraded to a 3 or worse, it is considered an unsatisfactory bank.
CAMELS
composite rating
Satisfactory

Unsatisfactory

Description

Financial institutions with a composite 1 rating are sound in every respect
and generally have individual component ratings of 1 or 2.

Financial institutions with a composite 2 rating are fundamentally sound.
In general, a 2-rated institution will have no individual component ratings
weaker than 3.

Financial institutions with a composite 3 rating exhibit some degree of
supervisory concern in one or more of the component areas.

Financial institutions with a composite 4 rating generally exhibit unsafe and
unsound practices or conditions. They have serious financial or managerial
deficiencies that result in unsatisfactory performance.

Financial institutions with a composite 5 rating generally exhibit extremely
unsafe and unsound practices or conditions. Institutions in this group
pose a significant risk to the deposit insurance fund, and their failure
is highly probable.

SOURCE: Federal Reserve Commercial Bank Examination Manual.

to unsatisfactory status during each quarter. The line
labeled “Large Banks” is calculated for comparable
changes in CAMELS ratings for the large banks examined each quarter. The quarterly downgrade rate for
community banks was about 9 percent in 1991 and
fell below 2 percent in the mid-1990s. Downgrade
rates for both community banks and large banks
rose temporarily to about 4 percent during some
quarters of 1998 through 2000. While the downgrade
rates for both groups of banks have been higher in
recent quarters than during the mid-1990s, the
current downgrade rates for both groups of banks
remain low relative to the rates of the early 1990s.

ACCESS TO CURRENT DATA
The data in this article are updated quarterly.
To provide an on-going picture of the condition of
community banks, the Federal Reserve Bank of St.
Louis will maintain on its web page the most current
data in each table in the data appendix to this article.
54

J A N UA RY / F E B R UA RY 2 0 0 3

In addition, the web page will provide the data in
Tables 2 through 7 for the banks in each of the nine
census divisions with total assets below $10 billion.
In the past the deterioration in the condition of banks
was concentrated in a few states, and this tendency
for an uneven geographic concentration of distress
among banks is likely to prevail in the future.7

CONCLUSIONS
The condition of most community banks, identified as banks with total assets below $1 billion,
has remained sound through the recent recession.
There is some evidence, however, of a rise in problem loans among community banks as a group
during recent quarters. For instance, the percentage of total loans that were nonperforming began
to rise at community banks during 2001. In con7

See FDIC (1997) for information on the geographic distribution of
bank failures during the 1980s and early 1990s.

Gilbert and Sierra

FEDERAL RESERVE BANK OF ST. LOUIS

Figure 2
Percentage of Banks with CAMELS Downgrades from 1 or 2 to 3, 4, or 5
Percent
35
30
25
Large Banks
20
15
10
5
Community Banks
0
Mar
91

Mar
92

Mar
93

Mar
94

Mar
95

Mar
96

Mar
97

Mar
98

Mar
99

Mar
00

Mar
01

Mar
02

NOTE: Community banks are banks with less than $1 billion in total assets, and large banks are banks with assets
greater than or equal to $1 billion. Data are quarterly.

trast, the nonperforming loan ratio for banks with
assets above $1 billion began rising after 1997. The
condition of banks in each size group, however,
remains much stronger than during the recession
that ended in 1991. The rate of downgrades (see
Figure 2) suggests that examiners are not detecting
a systematic deterioration in the condition of community banks.
Several studies conclude that a deterioration in
the condition of banks can have adverse effects on
economic activity, and some of this evidence is relevant for community banks. These studies of the
“credit crunch” focus on the late 1980s and early
1990s, however, and the present condition of the
banking industry in the United States remains much
stronger than it was during that time. The current
relatively strong condition of U.S. commercial banks
(both community banks and larger banks) suggests,
therefore, that the state of the banking industry is
not a hindrance to U.S. economic activity.

___________; Kyle, Margaret K. and Scalise, Joseph M. “Did
U.S. Bank Supervisors Get Tougher during the Credit
Crunch? Did They Get Easier during the Banking Boom?
Did It Matter to Bank Lending?” in Frederic S. Mishkin, ed.,
Prudential Supervision: What Works and What Doesn’t?
Chicago: University of Chicago Press, 2001.

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Berger, Allen N.; Demsetz, Rebecca S. and Strahan, Philip E.
“The Consolidation of the Financial Services Industry:
Causes, Consequences, and Implications for the Future.”
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___________ and Udell, Gregory F. “Did Risk-Based Capital
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Bernanke, Ben S. and Lown, Cara S. “The Credit Crunch.”
Brookings Papers on Economic Activity, 1991, 0(2), pp.
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Bies, Susan S. “Current Challenges of Community Banks.”
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Curry, Timothy J.; O’Keefe, John P.; Coburn, Jane and
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