What Is The Federal Reserve?

The central bank of the United States is the Federal Reserve System, or the “Fed.” Superficially, the Fed acts as the reserve holder and supplier of the private sector’s commercial banking system, which means that it takes in commercial banking deposits and coordinates loans between commercial banks. In practice, the Fed dictates banking policies, drives the direction of interest rates, acts as a funder of last-resort to large banking institutions, and even acts as de facto coordinator of the public equity and futures markets.

Although the Fed transformed during its 100 plus years, perhaps no shift is as dramatic as the relationship between the Fed and gold. At the time of its introduction in 1913, the Fed held gold certificates, which were paper issues representing a 100% claim on gold assets in the U.S. Treasury. For the first few years, the Fed only held money backed by gold. It didn’t take long for all of that to change, however. Now, it is illegal for U.S. citizens to make monetary exchanges with gold or gold-backed specie, and the Federal Reserve operates through un-backed federal reserve notes, which are better known as U.S. dollars.

The Federal Reserve Act of 1913

Oddly enough, the Federal Reserve Act of 1913 does not refer to a “central bank.” Scholar Richard H. Timberlake explains that the “reason for this omission was the term’s unpopularity with the populist wing of the Democratic Party…Therefore, the new institution could not be a ‘central bank.’” (At the time, the United States was the last remaining Western power without a central bank, which many in the country were proud of.) In modern times, however, it is both common and correct to refer to the Fed as America’s central bank.

The Act created twelve regional banks across the contiguous United States, the most important of which was the New York Fed. These banks were charged with:

“discounting notes, drafts, and bills of exchange arising out of actual commercial transactions…the volume of sales of paper [bank notes]…shall be governed with a view to accommodating commerce and business and with regard to their bearing upon the general credit situation of the country.”

Early on, the Fed’s proponents argued that the Fed should limit itself to preventing severe inflation and preventing bank runs. As time went on, however, the Fed’s responsibilities exploded far beyond its original charter.

How Fed Operations Expanded in the 20^th Century

The Fed had a relatively quiet first decade. Its major impact involved bank reserves—it reduced the required reserve ratios for member banks from an average of 21.1% in 1912 to just 9.8% in 1917, effectively doubling the money supply. (Some economists believe that this huge credit expansion fueled the unsustainable capital market growth in the 1920s.)

Major changes came with the Banking Acts of 1933 and 1935. These New Deal programs shifted power from the New York Fed to Washington D.C. and stripped Americans of the right to redeem their paper currency for gold bullion. The federal government confiscated its citizens’ gold and the Fed began growing the money supply far beyond its earlier constraints. The Fed also became the de facto lender of last resort on all demand deposits after the Federal Deposit Insurance Corporation (FDIC) sprung into existence.

After the New Deal, the federal government added an incredible amount of public debt to the nation’s ledger. The Fed became one of the major buyers of U.S. treasuries, effectively subsidizing government overspending. The Fed does charge interest on U.S. debt, but it immediately repays all interest back to the Treasury. Today, the Fed owns hundreds of billions in U.S. debt.

Most significantly, the Federal Reserve of the 21^st century actively pursues inflationary policy, the exact opposite duty it was charged with in 1913.

Today, the Fed operates by:

• Ordering new currency for commercial banks from the Bureau of Engraving and Printing
• Engaging in Open Market Operations to buy and sell securities (primarily U.S. treasuries). This is the chief mechanism that the Fed uses to influence interest rates
• Setting bank reserve ratios, lending standards, setting rates on overnight loans between banks and other smaller banking functions
• Providing other financial service, many of which are secret, to major banks or foreign governments

The Relationship Between the Fed and Gold

Today, the Federal Reserve’s relationship with physical gold bullion can be best described as antagonistic. Central banks, as a rule, distrust and dislike precious metals and precious metal standards, such as the Gold Standard or Silver Standard. This is because physical metals are scarce and difficult to inflate. Central banks want to be able to inflate, whether for their stated monetary policy goals or, from a more cynical perspective, to float massive government debts and enrich institutional financiers.

Capital market participants understand well the tension between real assets, such as gold and the fiat U.S. dollar currency. As such, the Federal Reserve maintains an indirect but significant influence over gold prices. The more that the Fed appears to ignore problems of national debt, inflation, and bubbles in asset markets, the more gold owners benefit.

The Fed’s Legacy

Its early defendants argued that the Federal Reserve System was necessary to offer a more flexible, robust, and stable monetary policy. Between the end of the Civil War in 1865 and the first decade of the 20^th century, the United States experienced a series of small banking panics, which The Federal Reserve was supposed to fix. Instead, the Fed oversaw a major depression from 1920 to 1921, the Great Depression of the 1930s, accelerating inflation in the 1970s, and the Great Recession, or the global financial crisis from 2007 to 2009.

With such a mixed legacy and a recent track record of experimental monetary policy, it is not surprising that many investors seek to protect their portfolio against central bank behavior by purchasing real assets—real estate, art, cars, airplanes, and physical bullion.

How Should Gold and Silver Investors React to the Fed

Gold remains the most popular precious metal for commodity investing, both in the United States and internationally. Silver is the second most popular investment metal, and it is particularly popular for Self-Directed IRA inclusion.

Gold and silver, which are universally recognized symbols of wealth and value, protect from inflation of fiat currencies. The good news is you can own real, physical gold or silver bullion and store it in a tax-advantaged retirement vehicle. American Bullion can discuss your options and help you every step of the way.