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PAY, PROFIT AND GROWTH, Part 4
Central banks and gold
By Henry C K Liu

This is the fourth article in a series.

Part 1: Stagnant wages leading to overcapacity
Part 2: Gold shows its true metal
Part 3: Labor markets delinked from gold

The official central bank gold holdings (listed by amount of gold) as of December 2010 are as follows, with the amount as a percentage of national foreign exchange reserves in brackets:
United States: 8,133.5 tonnes (about 73.9%);
Germany: 3,401.8 tonnes (about 70.3%);
IMF: 2,846.7 tonnes (not known);
Italy: 2,451.8 tones (about 68.6%);
France: 2,435.4 tonnes (about 67.2%);

 

China: 1,054.1 tonnes (about 1.7%);
Switzerland: 1,040.1 tonnes (about 16.4%).

Portugal, with only 382.5 tonnes, has the highest percentage of national forex reserve of 81.1%; Greece, with only 111.7 tonnes, has the next highest percentage of national forex reserve at 78.7%.

The low percentage of national forex reserve in gold for China is due to its large forex reserve holding. The high percentages for Portugal and Greece are due to the small size their forex reserves.

The gold listed above for each of the countries may not be physically stored inside the country as central banks generally have not allowed independent audits of their reserves.

Gold Holdings Corp, a publicly listed gold company, estimates that the amount of in-ground verified gold resources currently controlled by publicly traded gold mining companies is roughly 50,000 tonnes.

In 2008, central banks held about 18% of the world's gold, jewelry took up 52%, private investment held 16%, industry uses 12%; 2% was unaccounted for. As of October 2009, gold exchange-traded funds held 1,750 tonnes of gold for private and institutional investors.

Gold holding not a central bank prime function
Among the prime functions of a central bank is to issue the nation's currency that is legal tender for all debts, public and private, and to formulate monetary policy setting short-term interest rate (the cost of money) to maintain optimum economic growth without inflation, and by managing the money supply (the quantity of money) through setting the discount rate to sustain a robust economy.

The Federal Reserve, the US central bank, describes its role in setting the nation's monetary policy as "to promote the objectives of maximum employment, stable prices, and moderate long-term interest rates. The challenge for policy makers is that tensions among the goals can arise in the short run and that information about the economy becomes available only with a lag and may be imperfect". The role of gold is not mentioned.

It describes the goals of monetary policy as spelled out in the Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Market Committee (FOMC) should seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates".

The initial link in the chain between monetary policy and the economy is the market for balances held at the Federal Reserve banks. Depository institutions have accounts at their respective regional reserve bank, and they actively trade balances held in these accounts in the federal funds market at an interest rate known as the federal funds rate. The Federal Reserve exercises considerable control over the federal funds rate through its influence over the supply of and demand for balances at the reserve banks.

In the federal funds market, depository institutions actively trade balances held at the Federal Reserve with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances. The federal funds rate - the interest rate at which these transactions occur - is an important benchmark in financial markets. Daily fluctuations in the federal funds rate reflect demand and supply conditions in the market for Federal Reserve balances.

The FOMC sets the federal funds rate at a level it believes will foster financial and monetary conditions consistent with achieving its monetary policy objectives, and it adjusts that target in line with evolving economic developments. A change in the federal funds rate, or even a change in expectations about the future level of the federal funds rate, can set off a chain of events that will affect other short-term interest rates, longer-term interest rates, the foreign exchange value of the dollar, and stock prices. In turn, changes in these variables will affect households' and businesses' spending decisions, thereby affecting growth in aggregate demand and the economy.

Short-term interest rates, such as those on Treasury bills and commercial paper, are affected not only by the current level of the federal funds rate but also by expectations about the overnight federal funds rate over the duration of the short-term contract. As a result, short-term interest rates could decline if the Federal Reserve surprised market participants with a reduction in the federal funds rate, or if unfolding events convinced participants that the Federal Reserve was going to be holding the federal funds rate lower than had been anticipated.

Similarly, short-term interest rates would increase if the Federal Reserve surprised market participants by announcing an increase in the federal funds rate, or if some event prompted market participants to believe that the Federal Reserve was going to be holding the federal funds rate at higher levels than had been anticipated.

Thus the Fed funds rate has come to be regarded by the market as an indicator of the central bank's view on the current and future conditions of the economy and commensurate monetary policy responses.

Monetary aggregates have at times been advocated as guides to monetary policy on the grounds that they may have a fairly stable relationship with the economy and can be controlled to a reasonable extent by the central bank, either through control over the supply of balances at the Federal Reserve or the federal funds rate. An increase in the federal funds rate (and other short-term interest rates), for example, will reduce the attractiveness of holding money balances relative to now higher-yielding money market instruments and thereby reduce the amount of money demanded and slow growth of the money stock. There are a few measures of the money stock - ranging from the transactions-dominated M1 to the broader M2 and M3 measures, which include other liquid balances - and these aggregates have different behaviors.

On March 23, 2006, the Fed under Ben Bernanke stopped tracking M3, the broadest measure of US money supply, arguing it had not been used in interest rate decisions for some time, as if that was a rational justification rather than an operational neglect that needed to be corrected. The term "credit easing" reflects the Fed's focus on bank balance sheets, rather than "quantitative easing" which describes the boosting of the money supply. (See Bogged down at the Fed, Asia Times Online, September 11, 2009.)

Traditionally, the rate of money growth sought over time would be equal to the rate of nominal gross domestic product (GDP) growth implied by the objective for inflation and the objective for growth in real GDP. For example, if the objective for inflation is 1% in a given year and the rate of growth in real GDP associated with achieving maximum employment is 3%, then the guideline for growth in the money stock would be 4%.

However, the relation between the growth in money and the growth in nominal GDP, known as "velocity", can vary, often unpredictably, and this uncertainty can add to difficulties in using monetary aggregates as a guide to policy. The narrow and broader aggregates often give very different signals about the need to adjust policy. Accordingly, monetary aggregates have taken on less importance in policy making over time

Letting interest rates play a primary role in guiding monetary policy is problematic because of the uncertainty about exactly what level or path of interest rates is consistent with the basic goals of monetary policy. The appropriate level of interest rates will vary with the stance of fiscal policy, changes in the pattern of household and business spending, productivity growth, and economic developments abroad. It can be difficult to gauge the relative strength of these forces and to translate them into a path for interest rates.

The slope of the yield curve (that is, the difference between the interest rate on longer-term and shorter-term instruments) has also been suggested as a guide to monetary policy. Whereas short-term interest rates are strongly influenced by the current setting of the policy instrument, longer-term interest rates are influenced by expectations of future short-term interest rates and thus by the longer-term effects of monetary policy on inflation and output.

For example, a yield curve with a steeply positive slope (that is, longer-term interest rates far above short-term rates) may be a signal that participants in the bond market believe that monetary policy has become too expansive and thus, without a monetary policy correction, more inflationary. Conversely, a yield curve with a downward slope (short-term rates above longer rates) may be an indication that policy is too restrictive, perhaps risking an unwanted loss of output and employment. However, the yield curve is also influenced by other factors, including prospective fiscal policy, developments in foreign exchange markets, and expectations about the future path of monetary policy. Thus, signals from the yield curve must be interpreted carefully.

The Taylor rule
The Taylor rule, named after economist John Taylor, relates the setting of the federal funds rate to the primary objectives of monetary policy - that is, the extent to which inflation may be departing from something approximating price stability and the extent to which output and employment may be departing from their maximum sustainable levels. For example, one version of the rule calls for the federal funds rate to be set equal to the rate thought to be consistent in the long run with the achievement of full employment and price stability plus a component based on the gap between current inflation and the inflation objective less a component based on the shortfall of actual output from the full-employment level.

If inflation is picking up, the Taylor rule prescribes the amount by which the federal funds rate would need to be raised or, if output and employment are weakening, the amount by which it would need to be lowered. The specific parameters of the formula are set to describe actual monetary policy behavior over a period when policy is thought to have been fairly successful in achieving its basic goals.

Although this guide has appeal, it has shortcomings. The level of short-term interest rates associated with achieving longer-term goals, a key element in the formula, can vary over time in unpredictable ways. Moreover, the current rate of inflation and position of the economy in relation to full employment are not known because of data lags and difficulties in estimating the full-employment level of output, adding another layer of uncertainty about the appropriate setting of policy.

Foreign exchange rates
Exchange rate movements are an important channel through which monetary policy affects the economy, and exchange rates tend to respond promptly to a change in the federal funds rate. Moreover, information on exchange rates, like information on interest rates, is available continuously throughout the day.

Interpreting the meaning of movements in exchange rates, however, can be difficult. A decline in the foreign exchange value of the dollar, for example, could indicate that monetary policy has become, or is expected to become, more accommodative, resulting in inflation risks. But exchange rates respond to other influences as well, notably developments abroad; so a weaker dollar on foreign exchange markets could instead reflect higher interest rates abroad, which make other currencies more attractive and have fewer implications for the stance of US monetary policy and the performance of the US economy. Conversely, a strengthening of the dollar on foreign exchange markets could reflect a move to a more restrictive monetary policy in the United States - or expectations of such a move. But it also could reflect expectations of a lower path for interest rates elsewhere or a heightened perception of risk in foreign financial assets relative to US assets.

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