The Federal Reserve System, or sometimes referred to as “the Fed” is the central bank of the United States. The agency was created through the House Resolution 7883 by Rep. Carter Glass and it came into effect on December 23, 1913 after President Woodrow Wilson signed the Federal Reserve Act. The Fed is entrusted with the responsibility of ensuring that the country will have a safer, more stable, and flexible financial and monetary system.
The responsibilities of the Fed basically fall into four general categories:
- US monetary policy – influences credit and money conditions within the economy for the purpose of stabilizing prices and generating employment
- Supervision and regulation – it oversees and regulates the nation’s banking institutions and protect the rights of consumers.
- US financial system – systematic risks that may arise from activities in the financial market are contained to prevent its spread.
- Financial services – the Fed also provides certain financial services to the public, the government, financial institutions, and even foreign institutions. It plays an important role in balancing the country’s payments system.
Structure of the Federal Reserve
The Federal Reserve is designed to have a broad perspective of the overall economy and economic activities in different parts of the United States. The Fed has a central agency in Washington, D.C. – the Board of Governors, and twelve regional branches. Its regional centers are located in major cities throughout the country. All Federal Reserve Banks share the responsibility of monitoring and regulating financial activities throughout the country and for ensuring that the public receives adequate information. They also have to provide services to federal government and to depository institutions.
One major component of the System is the Federal Open Market Committee (FOMC). This committee is composed of the Federal Reserve Bank of New York president, members from the Board of Governors, and four Federal Reserve Bank heads (serving on a rotating basis). The FOMC influences money market conditions in the economy.
As the central bank, the Federal Reserve gets its authority from Congress. However, it is also considered independent because its decision doesn’t have to be ratified by the executive or legislative branch. The Fed also does not receive funding from Congress although it is subject to Congressional oversight. Its funding is mainly derived from the interest on US government securities which is generated from open market operations. Other sources of funding are derived from interest on foreign currencies, fees for services, and interest on loans to depository institutions. Earnings will be sent to the US Treasury.
Fed and Monetary Policy
The Fed is in charge of U.S. monetary policy. Monetary policy affects the economy via determining the money supply and interest rates. We say that monetary policy is expansionary (or loose, or dovish) when it expands the money supply and lower interest rates. It is traditionally used to combat unemployment during recessions. On the other hand, monetary policy is contractionary (or restrictive, or hawkish) when it tightens the money supply and raises interest rates. It is used to control inflation.
Fed and Gold Price
As the Fed shapes U.S. monetary policy, it influences significantly the macroeconomic environment and, thus, also the gold market. The link between the U.S. central bank and the yellow metal is manifold. First of all, the Fed set the federal funds rate, which affects short-term interest rates and, indirectly, the whole structure of interest rates in the U.S. economy. Hence, when the Fed tightens its monetary policy, interest rates rise. When they increase faster than inflation, real interest rates go up, which is negative for gold, a non-yield-bearing asset. On the contrary, when the Fed eases its monetary policy, interest rates decline. When they decrease faster than inflation, real interest rates go down, which is positive for the yellow metal.
Investors should remember that real interest rates are much more important for the price of gold than the federal funds rate. As one can see in the chart below, there is no strict correlation between the federal funds rate and the price of gold, and there were many cases when the tightening cycle was accompanied by upwards moves in the price of gold.
Chart 1: Effective federal funds rate (green line, left axis, in percent) and the price of gold (yellow line, right scale, London P.M. fixing) from 1968 to 2017.
Second, gold is a safe-haven asset, a bet against the U.S. economy. Investors purchase the yellow metal when their confidence in the U.S. dollar and the Fed’s ability to control economy diminishes. On the contrary, if the Fed inspires the investors’ confidence in the economy, they increase their risk appetite and shift their funds from safe havens into more risky assets.
The best example of the Fed’s important impact on the gold market may be its quantitative easing program. Initially, after the financial crisis of 2008, quantitative easing was positive for the price of gold. It was a new and unprecedented program, which undermined the investors’ confidence and brought a fear of inflation or even hyperinflation. However, when the U.S. economy recovered after some time and there was no inflation on the horizon, the confidence in the Fed and the economy increased. Thus, the price of gold entered a bear market in September 2011, just two months after the end of the second round of quantitative easing.
We encourage you to learn more about the gold market – not only about the link between the Fed and the price of gold, but also how to successfully use gold as an investment and how to profitably trade it. A great way to start is to sign up for our gold newsletter today. It's free and if you don't like it, you can easily unsubscribe.