How the Fed Lost Control of Monetary Policy

By Dr. Jeffrey Lewis  Feb 24 2010 11:29AM

While investors contemplate the recent increase in the Federal Funds rate, astute investors realize this arbitrary figure means nothing in regards to fighting inflation or decreasing the money supply. Although the Federal Funds rate may have made an impact in 2008, its impact on the market was lost after the Fed expanded the balance sheet to buy illiquid assets in late 2008 through 2009.

The Federal Funds Rate

The Federal Funds rate is the rate that is usually thrown around investing discourse when the Fed seeks a new target.  The Federal Funds rate is the rate set by the Fed through its open market policies, and it is the price at which reserves are lent overnight from one member bank to another.  When banks have excess reserves to lend, or if they need to borrow additional reserves from other banks, they do so at this price. 

The actual rate, of course, depends on supply and demand; however, the Fed conducts open market operations with primary dealers to influence the rate within their target.  The Fed can temporarily add or subtract reserves to or from the market, but these mechanics are only applied in the short term.

The Federal Reserve Discount Rate

The discount rate is on par with the Federal Funds rate, but earns very little discussion in the press and even in investing circles. This rate is set by the Fed and is the price at which the Federal Reserve branches lend reserves to other institutions.  Typically, banks that use this mechanism to achieve greater reserves are in dire need of cash for the medium term.

Why These Rates Don't Matter

When the Federal Reserve acts to raise rates, most investors perceive this as an inflation-fighting mechanism, when in today's market, it has little to no effect. The simple truth is that the rates the Federal Reserve sets for its member banks are only important when banks are short on reserves and thus have to borrow from other banks. 

However, as we all know, the quantitative easing programs enacted by the Federal Reserve bought Agency debt, as well as Treasuries, for a price that may have well been above market price, and the program settled the transactions with reserves at the Fed.  The result is that the full $1.2 trillion quantitative easing program was deposited directly into the reserve accounts of these banks. Thus, there isn't a single bank operating in the United States that does not have enough reserves, as Federal Law mandates that banks need only $1 in reserve for $10 in loans.

How the Fed Can Use Monetary Policy

Knowing now that the target rates set by the Fed are nothing but a scheme for good press, you're now wondering what the Fed would have to do to curb the amount of money in circulation.  The Federal Reserve, to decrease the available money supply, must now act to sell off its assets in exchange for reserves from member banks – which are then kept off the market and in the hands of the Federal Reserve.  Without selling the assets it purchased from 2008 to 2009, there is no way the Federal Reserve can decrease the money supply, especially not to the same degree at which it increased it in just two years.

Renewed Interest in a Tax on Stocks Proves Metals Are the Place to Be

In an unprecedented modern move, the Federal government is considering a new investment tax as a way of paying for a huge annual deficit.  The investment tax would cost investors .25% on purchases of stocks and exchange-traded funds outside of retirement accounts and would generate an estimated $90 – $100 billion in annual income for the US Treasury.

Nothing is Safe

If there is anything that the Federal Government has proven in the past two years, and even many years prior, no amount of private property is safe from the power-hungry arm of government.  SEC rules have already declared that the government has the right to seize investors assets in time of intense economic hardship, and this new bill drafted by Congress opens the door for the government to steal parts of your wealth via taxation, if only penny by penny. Although the new .25% tax would generally have little effect on investor wealth, it opens the door for confiscation of larger quantities of your investment dollars via taxation.

Metals and Taxation

Though capital gains taxes on gold and silver are hardly favorable for investors since metals are taxed like collectables, perhaps metals investors are getting a better deal after all. The new taxation scheme is garnering some attention and traction among lawmakers, with 27 members of the House now co-sponsoring the bill.  Lawmakers are increasingly interested after learning that a similar scheme in the United Kingdom generates $30 billion annually, and it has met very few complaints.  However, passing such bill in this political climate seems difficult, if not impossible, but tax hikes are eventual should the government continue to spend like there is no tomorrow.

Gold and Silver Safety

Luckily, should an investment transaction tax be enacted, gold and silver in the form of coins and rounds will remain untaxed, while metals trading on the open market in futures contracts would be taxed. This presents an interesting opportunity for investors to begin revving up their purchases of physical gold and silver before a tax of this magnitude has even come to a vote. As we all know, new taxes can appear in a matter of weeks, and as the budget deficit grows, so does the incentive for lawmakers to pass a new tax, especially on the Wall Street so many politicians condemn.

A New Discussion

It should be settled that no investment, large or small, is ever out of the jurisdiction or interest of the Federal Government, and all vehicles are open to all new forms of taxation. With Congress considering a slew of anti-investing bills that can seize your assets, create forced deposits into new “R-bonds” (Treasury bonds rebranded for retirement accounts), and now even tax each and every investment you make, it’s time to try something new. 

With all these laws on the table, and the investing public demanding safety, investors can be sure that the few instruments that will truly protect their wealth is physical gold and silver. Nothing else can protect your assets from inflation or taxation.

Dr. Jeff Lewis

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Dr. Jeffrey Lewis, in addition to running a busy medical practice, is the editor of Silver-Coin-Investor.com and Hard-Money-Newsletter-R eview.com