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Federal Reserve and its Balance Sheet

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Federal Reserve and its Balance Sheet

Federal Reserve (The Fed) is the central bank of United States of America. It produces (prints) US Dollar Notes as the country’s currency.

The Federal Reserve System has both private and public components. It was designed to serve the interests of public and private bankers. The result is a structure that is unique among central banks. Originally, the Federal Reserve was required by law to have enough gold to back 40 percent of its issued dollar notes.

At the time of creation of the Fed in 1913, the official mint parity between U.S. dollar and the Sterling Pound was approximately $4.87 based on the US official gold price of $20.67 per ounce and the UK official gold price of £4.24 per ounce.

In 1933, the US President Franklin Roosevelt imposed a ban on US citizens to own gold. The US citizens were then forced by law to sell the gold in their possession to Federal Reserve at price of $20.67 per ounce. Once citizen's gold was collected, the government devalued in January 1934 the US dollar. This action raised the official price of gold from $20.67 to $35 overnight. This represents more than 65 percent of devaluation for the dollar. At the same time, it constitutes 65 percent indirect taxation of US gold owners by the government.

For US citizens, the Federal Reserve notes have not been redeemable in gold since January 30, 1934, and in silver, since 1960s.

After World War II, the Breton Woods Agreements established a system, sometimes described as the gold exchange standard. The rationale behind this agreement was possession then by United States of some 80 percent of the world’s gold reserves. Under this system, many countries fixed their currency exchange rates relative to US dollar. Foreign central banks could then exchange their dollar holdings in gold at the predefined official exchange rate of $35 per ounce of gold. This option was available only to the signatory foreign central banks, but not to firms or individuals. All currencies were pegged to the dollar and thereby had a fixed value with $35 per ounce of gold. Many foreign countries then decided to store US dollars in their central banks instead of physical gold for logistic reasons.

Starting from late 1950s, some European countries realized that owing to US stealth Money Printing policy, the dollar had lost value against gold. Therefore, they started to exchange their dollar reserves for gold of United States. This was sometimes called the US gold draining period.

In 1971, the Breton Woods agreement broke down. This happened because the Federal Reserve stealth money printing operations had resulted in loss of trust of foreign government in US dollar. They were bringing massive amount of their US dollars with warships to exchange against US gold at the agreed price of $35 per ounce. Consequently, this resulted in a significant drop in the US gold reserves.

In 1973, the US government definitively and unilaterally abandoned the gold standard. Due to breakdown of fixed exchange rate, the US government devalued the dollar twice but then gave up the attempt of fixing its price in terms of gold.

Since 1973, the US dollar notes are backed neither by gold, silver, nor any other tangible object. It became a fiat currency.

The Federal Reserve Balance Sheet

Up to March 2009, Federal Reserve owned some $475 billion worth of bonds. Since then, it has inflated it to some $4,300 billion at the end of 2014. Figure 13.2 shows a chart of Federal Reserve’s balance sheet that is meanwhile eight times bigger, in a record time of approximately six years. Federal Reserve has given a loan of 77 dollars for each of its own.

13-2Figure 13.2

It is worthwhile highlighting that during financial crisis of 2008, the Fed balance sheet shrunk from some $800 billion down to some $450 billion. The associated liquidity contraction of some $350 billion then resulted in a DJ-30 loss from the high of some 14,200 down to 6,500, or a loss of 54%. You may then imagine the effect of potential liquidity contractions from $4.3 trillion down to $450 billion on DJ-30 index.

What is the quality of bonds in the Fed vaults? Since the financial crises of 2008, the Fed has taken two drastic lines of action. First, it has lowered the short-term interest rate to something between zero and 25 basis points or between 0 percent and 0.25 percent per year. The intention was to create economic stimulus, mitigate the real estate losses of previous sub-prime crisis, and enable industries to invest in production systems. However, the Fed seems to have neglected the long-term consequences of such short-term policy. The real estate speculators have re-created a new housing bubble and  public companies have bought their own shares to recreate another stock market bubble. The Fed’s second line of action was to buy the Treasury securities aggressively. The purpose of this action was to put a downside pressure on the longer-term interest rates. This way, the interest rates remain low, not only for the overnight and short term Treasury Bills, but also for the longer-term Treasury T-Notes and Bonds. For the Fed, buying Treasury Securities means that it lends money to the government at a low rate of interest and keeps the bonds as collateral and guaranty.
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