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What Is The Federal Reserve?

The Federal Reserve System was established on December 23, 1913 with the enactment of the Owen-Glass Act also known as the Federal Reserve Act, making the Federal Reserve System (The Fed) the central bank of the United States.

The Federal Reserve System consists of twelve regional Federal Reserve Banks located in major cities throughout the United States – Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas and San Francisco.

Board Of Governors Of The Federal Reserve System

The Board of Governors, also known as the Federal Reserve Board, located in Washington D.C., is the central board of seven of those regional banks.. The seven governors are appointed by the president and confirmed by the Senate, however despite this government involvement, the Federal Reserve is a private corporation, not a government agency.

The Board’s primary responsibility is participating in the Federal Open Market Committee (FOMC), which conducts monetary policy for the United States, with the seven Board of Governors comprising the voting majority of the FOMC in addition to the other votes coming from the remaining five Reserve Bank presidents.

Primary Goal Of The Federal Reserve System Is…

The Federal Reserve has established with three core principals:

It was created by the Congress to provide the nation with a safer, more flexible, and more stable monetary and financial system.

Or, as the Federal Reserve stated itself:

…to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.

But since that doesn’t make much sense here it is in simple terms:

The Federal Reserve (private corporation) is granted legal supremacy (monopoly) in the geographic region of the United States to be the sole issuer of currency (legal tender), alongside the US Government, in the United States, commonly known as the Federal Reserve Note or the United States Dollar, backed by the United States Treasury (government organization).

How The Federal Reserve “Creates Money”

Firstly, you may find our use of the terms currency and money uncommon, that is because the mainstream definition of these two terms is slightly inaccurate.

Here is how we define currency and money:

  • Currency – a unit of account that is durable, portable, divisible, and interchangeable which serves as a medium of exchange

  • Commodity – a raw material in finite supply that is in demand for consumption or production

  • Money – a currency that is a commodity.

For anything to qualify as money, it must have a tangible use outside the realm of being a currency (medium of exchange). Money is the currency that, also, is utilized in the production of goods and services.

For example, if you have a copper coin, you can melt it and use it in the creation of a copper wire for the electricity in your home, vice versa. The Federal Reserve Note (FRN) (United States Dollar, USD) is a currency and is not money because it has no tangible use as a commodity. Thus, it relies entirely on its investment value.

While the Federal Reserve itself does not print currency, it does acquire it from the US Treasury:

Federal Reserve Banks obtain the notes from our Bureau of Engraving and Printing (BEP). It pays the BEP for the cost of producing the notes, which then become liabilities of the Federal Reserve Banks, and obligations of the United States Government.

Interestingly, the Federal Reserve ardently denies that it prints currency:

Is the Federal Reserve printing money in order to buy Treasury securities?

No. The term “printing money” often refers to a situation in which the central bank is effectively financing the deficit of the federal government on a permanent basis by issuing large amounts of currency. This situation does not exist in the United States.

The discrepancy in language (semantics) arises from the fact that the Federal Reserve Note is a liability of the Federal Reserve Bank to any holder of those notes. Therefore, if you hold a $5 bill in your wallet, that is not wealth in itself, but a promise (bond) of the Federal Reserve to compensate you $5.  By law the Federal Reserve cannot have this liability of $5 without a matching $5 in assets on its books. if you are familiar with accounting 101, assets = liability + equity. Which begs the question, what is $5 dollars in itself if it is not that piece of paper that you have in your wallet?

Here’s proof that the notes have “no value for themselves”:

Federal Reserve notes are not redeemable in gold, silver or any other commodity, and receive no backing by anything This has been the case since 1933. The notes have no value for themselves, but for what they will buy. In another sense, because they are legal tender, Federal Reserve notes are “backed” by all the goods and services in the economy.

As such, let us ask ourselves a question – How do Federal Reserve Notes come into existence and how and why is the balance sheet of the Federal Reserve filled with US Treasuries (US government bonds), along with mortgage backed securities amongst other assets? How is the Federal Reserve able to purchase government bonds from the US Treasury, if not through the use of already existing or newly issued Federal Reserve Notes?

Don’t forget the US debt has been increasing, not decreasing, and not all of this new debt is funded by private, foreign or sovereign investors. This explains the rise in the Federal Reserve balance sheet (assets and liabilities) from under $900 billion since 2008 to just under $4.5 trillion as of March 2017. At the same time US  government debt has expanded from $10 trillion in 2008 to just under $20 trillion as of March 2017.

How The Federal Reserve Works?

Following the 2008 financial crisis, in 2009 Congress tasked the Federal Reserve with increased responsibilities:

…[including] supervising and regulating banks, maintaining the stability of the financial system and providing financial services to depository institutions, the U.S. government, and foreign official institutions.

Through the control of the creation and the supply of currency the Federal Reserve therefore has the power to create currency with the power of a printing press to provide artificial liquidity to the marketplace in the event that lending between banks, individuals, or institutional or foreign investors and governments slows or ceases.

After obtaining the currency from the US Treasury the Federal Reserve subsequently controls the currency supply, commonly referred to as the “money supply” or M2 for short.

The Federal Reserve can just “influence the availability and cost of money”:

The term “monetary policy” refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals.

Additionally, the Federal Reserve has the power to set the interest rate in the United States through a mixture of policy tools, including what is commonly known as quantitative easing or QE for short.

Through QE a central bank will sell newly created currency (notes) to member banks. This is equivalent to you owning a printing press and creating currency for yourself and your family. In theory, the banks, now with increased reserves as a function of the newly obtained currency would lend it to businesses, consumers, investors and so forth – thereby driving the economy and stimulating investment and consumption.

In addition to the distribution of currency to member banks, the central bank purchases long-term debt from the government (Treasury). Again, the theory that the central bank is working under is that through the purchasing of bonds with newly issued currency, this increases the demand for bonds, thereby pushing the prices of bonds higher and likewise moving the interest rate lower.

You can read more about how bonds and interest rates work in: Interest Rates Vs. Bond Prices: How Do Bonds Work?

The Federal Reserve Balance Sheet

Since 2008, the Federal Reserve has increased its assets by purchasing US Treasuries, mortgage backed securities, and other assets through the creation of newly issued currency (Federal Reserve Notes).

Here is a chart showing the asset increases implemented through various Federal Reserve open market programs such as quantitative easing:

The philosophy behind quantitative easing:

At the heart of quantitative easing is the belief that when there is no economic growth that through intervention governments can stimulate growth, however this has its limitations and dangerous consequences. The school of economic thought that is closest attributed to this policy of government intervention in markets is the Keynesian School of Economics, modeled after the late John Maynard Keynes.

When government intervenes in the economy and increases the currency supply (inflation), if funded through debt, this is called deficit spending as it increases the government’s budget deficit.

However, one major shortcoming of this approach is that it increases imbalances within the economy by stimulating demand through the facilitation of cheap credit availability and newly issued currency – something that cannot and will not happen indefinitely.

Therefore, what happens when the availability of cheap credit and newly issued currency disappears?

However, despite the Federal Reserves and the governments best efforts to stimulate the economy, this has not quite worked out as intended. Instead of this newly issued currency flowing into the economy to help spur lending and economic growth, it has largely been funneled into assets like real estate, equities and bonds, all of which has driven these asset prices to historic high levels.

The Federal Reserves primary objective with the implementation of quantitative easing was to increase the “velocity of money” (it should be called velocity of currency in this case). The velocity of money is the measurement of the rate at which money is exchanged from one transaction to another in a given period of time.

In fact, the velocity of money has actually been declining:

The process of creating currency does not have a linear impact whereby the Federal Reserve, now having increased its reserves, would allow the member banks to lend currency to businesses and people.

Here’s why:

A bank’s primary function is to make a return on investment, to make a profit. One of the primary ways they do this is by lending to borrowers at an interest rate that is higher than the cost of obtaining the newly printed currency from the central bank – the difference (spread) thus making up the profit. They charge an interest rate for the money they lend out. Additionally, the power of fractional reserve banking allows the bank to use $1,000 in deposits (actual currency received from depositors) and to lend out a little over $9,000 from that $1,000. This is where the so called stealth quantitative easing comes into play.

The currency that banks use to lend out comes from fractional banking derived by the deposits from their customers. The bank pays interest on the deposits from these accounts. The bank’s profits are the differential from what is paid to depositors versus what is charged to its lenders.

If you were a bank you would want to maximize the potential of the differential. You would want to pay as little in interest as you could from borrowing while at the same time receive as much interest as you could from lending.

As such, while asset classes such as real estate, stocks and bonds have reached new all time highs, GDP growth, a measure of economic growth has been tepid at best:

This tepid GDP growth has occurred in spite of the historical currency creation and expansion of the Federal Reserve balance sheet. If that level of financial stimulus cannot get the economy moving, what will?

Fed Interest Rates & Rate Increase

The purpose behind the Federal Reserve raising the fed funds rate is to increase the dividend that it will pay to its member banks for their storage of reserves at the Federal Reserve. Don’t worry, this does not mean you will earn more on your savings or deposit account necessarily.

In theory, if the economy is experiencing rapid inflation in excess of established targets then the Federal Reserve would increase the interest rate, thereby increasing the cost of lending and reducing your ability to purchase a car, home or anything else on credit as it becomes more costly for you.

For example, if a new car costs $25,000.00 to purchase with 60 monthly payments and interest rates are at 5%, the monthly loan payment is $472.00. But, at 6% that same loan will go up to $483.00 monthly.

That may not seem like a lot for any one individual, but there are some 17.6 million vehicles sold in the United States annually. If you added $132.00 ($11 x 12 months) to every car sold in America that is $2.3 billion annually in costs that are not helping the economy grow, but merely the cost of servicing debt. Imagine what rising interest rates would do to the whole economy? You can read an in-depth discussion of how debt affects you here.

The mainstream understanding for why rates are rising is that this is due to stem economic growth. This begs the question, what growth? Certainly the goal of raising borrowing costs for an economy which is barely moving at historically low interest rates is not to help it speed up, which can only mean one thing – the economy will slow down. We aren’t talking about voodoo magic here.  You can’t have your cake and eat it too.

What Does This Mean For You?

Unless the economy experiences a substantial catalyst that would incentive businesses and growth, such as tax reform, part of which is the Affordable Health Act reform, or improved global demand for US products (the US is a net importer not an exporter), then the economic outlook is rather bleak to put it mildly.

The greatest financial risk that you may be predisposed to during a downturn in the economy is if you owe debt. While asset classes such as real estate, bonds and equities would likewise negatively be influenced by a slowing of the economy, there is a growing risk of the market losing confidence in the Federal Reserve to be able to steer the economy (a complex system) perfectly. As such, if the Fed is not too careful they risk pushing interest rates up rapidly, choking off the economy. Likewise, if the Fed is not delicate enough then there will be too much currency which could increase price inflation of consumer goods at a much faster pace. Therefore, rather than placing your hope in politicians to fix your problems for you, the power is within you to improve your financial well being regardless of what is decided in Washington DC.

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