Central Bank Gold Operations and its Ramifications

AN ENIGMA WRAPPED IN AN ANOMALY

Since late-1993 U.S. financial and commodity markets have experienced notable price inflation - as measured by the S&P 500, the CRB and Goldman Sachs Commodity (GSCI) Indexes. The financial markets demonstrate unprecedented "IRRATIONAL EXUBERANCE" - as the Fed Chairman aptly describes it - while the CRB and GSCI display only very modest appreciation. Specifically, the stock market has risen 116% to an all-time high greater than 940 (S&P 500). And the agriculturally oriented CRB is up a mere 9%, while the energy weighted GSCI has done a little better, rising 15% during the same period In sharp contrast gold has been prevented from reflecting the general, across the board increase in values enjoyed by all other types of investment assets. With a short respite of rising gold prices in early 1996, the yellow metal has on-balance dwindled in value. From late-1993 the Midas metal has indeed declined by 3% from $333 to $324.

What is holding the gold price down vis-à-vis relentlessly rising financial assets and most commodities? The supply/demand dynamics of the yellow metal are at the best levels in memory - so why is its value so prostrate? Why is gold's price so stagnant, and why is volatility low and falling in the face of accelerating yearly production deficits - now between 1,000-1,400 tons per reputable international experts? Why is gold's volatility at all-time record low levels versus the normal or extremely high volatility of all other types of investments? How can gold's Open Interest (COMEX) be at near record high levels with diminishing volume and practically no price volatility?

WHO HAS THE MEANS TO CONTROL THE WORLD MARKET PRICE OF GOLD?

To answer this question one may categorically exclude the possibility that producers, users or large speculators might be the perpetrators of this price manipulation. The reason for their exclusion is quite elementary. Firstly, commodity price control (read manipulation) is definitely against the law - they wouldn't dare!. Secondly, and most importantly, neither producers, users nor large speculators - acting jointly or independently have the wherewithal (i.e. financial clout) to effectively, and over a prolonged period control the market price of gold in order to maintain it range bound. That leaves only one candidate, who has both means and motive for the job: Central Banks.

WHO IS THE FEDERAL RESERVE BANK OF NEW YORK?

Before we address the specific purpose of this report, it is necessary to define the Federal Reserve System and enumerate the functions of its most important member, the Federal Reserve Bank of New York. Also relevant to our purpose is a description of the FRB's accounting practices - and pertinent observations regarding its 1995 Balance Sheet and Statement of Income.

The Federal Reserve Bank of New York is one of 12 regional Reserve Banks which, together with the Board of Governors in Washington, D.C., comprise the Federal Reserve System. The "Fed," as the system is commonly called, is an independent governmental entity created by Congress in 1913 to serve as the central bank of the United States. It is responsible for formulating and executing monetary policy, supervising and regulating depository institutions, providing an elastic currency, assisting the federal government's financing operations and serving as the banker for the U.S. government.

The New York Fed has supervisory jurisdiction over the Second Federal Reserve District. Though it serves a geographically small area compared with those of other 11 Federal Reserve Banks, the New York Fed is by far the largest Reserve Bank in terms of assets and volume of activity. When it comes to operations involving gold, the New York Fed may be thought of as the surrogate for the entire Federal Reserve System.

Unique International Functions -

In addition to its domestic trading desk responsibilities, the New York Fed, at the direction of the FOMC and Treasury, conducts all foreign exchange trading for the U.S. Treasury and the Federal Reserve System. In this role, the New York Fed intervenes in foreign exchange markets (FOREX) to achieve dollar exchange rate policy objectives and to counter disorderly conditions in foreign exchange markets.

The New York Fed has several unique responsibilities, including conducting open market operations, intervening in foreign exchange markets, and storing monetary gold for foreign central banks, governments and international agencies. Foremost is the implementation of monetary policy, one of the three missions of the New York Fed. The other two are international operations, and supervision and regulation.

The New York Fed also is responsible for maintaining relations with, and providing financial services for, *FOREIGN CENTRAL BANKS* and international organizations.One of these services is the New York Reserve Bank's unique custodial responsibility for the gold reserves of about *60 (SIXTY) countries*, central banks, and international organizations. Stored inside the vaults of this imposing structure are hundreds of billions of dollars of gold and securities. The New York Fed's gold vault, containing the largest known accumulation of monetary gold in the world, rests on the bedrock beneath Manhattan, in the Bank's basement 80 feet below street level. *In fact the FRB of New York stores about one-third of the world's official gold stock, about 12,000 tons - valued at approximately $125 billion at current market prices!* It is imperative to appreciate that this gold stash represents almost six years of the western world's annual mine production!

Foreign official gold reserves have been held at the New York Fed since 1924 for numerous reasons, including the stability of the U.S. political system, the concentration of international trade and finance in New York City, and the convenience of centralizing gold holdings in a place where international payments can be made quickly.

Intervention In Foreign Exchange Markets -

Before proceeding with this report it would be meaningful to establish a comprehensive definition of the word "CURRENCY." CURRENCY, per several word sources means: legal tender; money in circulation or medium of exchange; coin (including gold coins) or bank notes; Federal Reserve Notes; certificates and general use or acceptance.

Although the FRB and U.S. Treasury will not admit that gold bullion is money or legal tender, it nevertheless possesses 262 million ounces of the yellow metal for payment of international debts when necessary. Throughout history and through most of the world, gold is considered money. The FRB and U.S. Treasury's stubborn refusal to recognize gold as money is as absurd as its ridiculous balance sheet value of gold at $42.22 per ounce.

• The U.S. monetary authorities may sometimes intervene in the foreign exchange (FOREX) market to influence market conditions and/or the value of the dollar.
• The U.S. Treasury, in consultation with the Federal Reserve System, has responsibility for setting U.S. exchange rate policy, while the Federal Reserve Bank of New York is responsible for executing FOREX intervention.
• The New York Fed buys dollars on the FOREX market to increase the value of the dollar and sells dollars to decrease its value.

Foreign exchange intervention is the process by which the United States monetary authorities attempt to influence market conditions and/or the value of the U.S. dollar on the foreign exchange market. This is done to try to promote stability by countering disorderly markets, or in response to *special circumstances.*

Role of the Federal Reserve System in Foreign Exchange Policy -

Although the U.S. Treasury has overall responsibility for foreign exchange policy, its decisions are made in consultation with the Federal Reserve System. Intervention is conducted by the Federal Reserve Bank of New York on behalf of the U.S. monetary authorities. If a decision is made to support the dollar's price against a currency, the foreign trading desk of the New York Fed will buy dollars and sell foreign currency; to reduce the value of the dollar, it will sell dollars and buy foreign currency.

Not all trading desk activities in the market are directed by the U.S. Treasury or undertaken to influence the strength of the dollar. Indeed, on many occasions the New York Fed acts as agent on behalf of *other central banks* and international organizations wishing to participate in the FOREX market in the United States, with funds kept for those organizations in Federal Reserve custody accounts (naturally, in New York) and with no money of U.S. monetary authorities involved.

The Intervention Process -

When intervening on behalf of U.S. monetary authorities, the New York Fed uses varied intervention techniques, depending on the circumstances and goals of the operation.The trading desk may either deal directly with commercial banks or ask a commercial bank to deal on its behalf. *The latter technique is useful if the Fed wishes to act discreetly.*

The Federal Reserve *typically* deals in the spot market, which involves the simple buying and selling of currencies, as opposed to the derivative markets, which involve products such as options and futures. *It is imperative to note that the word "typically" DOES NOT MEAN EXCLUSIVELY.*

Interventions may be coordinated with *OTHER CENTRAL BANKS*, especially with the central bank of the country whose currency is being used. *Cooperation between CENTRAL BANKS* tends to increase the likelihood that intervention will be effective.*

How the Federal Reserve System is Audited -

*ONLY INTERNALLY*

All Federal Reserve Banks and branches are audited *INTERNALLY* and examined regularly based on specific risk factors in their operations. It is important to appreciate that *INTERNALLY means by Fed employees - NOT OUTSIDE INDEPENDENT AUDITORS.*

The scope and frequency of audits are based on the specific risk factors in each Bank's operations.

*Internal* audits primarily involve verification of assets, liabilities and items held in custody. Please note there is conspicuous absence of any mention of the Statement of Income.

(Internal) Auditors evaluate the adequacy of internal controls and compliance with prescribed procedures. Major automated systems are also checked for security.

Periodic Reviews and Examinations -

All Federal Reserve Banks and branches, like commercial depository institutions, are audited (internally) and examined regularly.

*INTERNAL* audits are conducted by a permanent audit staff at each Reserve Bank. Each audit staff is headed by a general auditor who reports directly to the Bank's board of directors. In addition, the Federal Reserve Board's Division of Federal Reserve Bank Operations and Payment Systems conducts annual examinations of each Reserve Bank and its branches.

Procedures used by the Board's examiners are periodically surveyed and appraised by a private certified public accounting firm. (The Board is audited by the staff of the Inspector General's Office and examined by a private CPA firm.)

PLEASE NOTE IT CLEARLY STATES THAT *ONLY* THE PROCEDURES ARE SCRUTINIZED BY A PRIVATE CPA - NOT THE ACTUAL BALANCE SHEET AND STATEMENT OF INCOME. FURTHERMORE, UNLIKE ALL U.S. CORPORATIONS THE Federal Reserve Bank of New York's ANNUAL REPORT CONTAINS NO INDEPENDENT AUDITOR'S REPORT STATING THE FINANCIAL STATEMENTS HAVE BEEN EXAMINED - AND ATTESTING THAT STATEMENTS WERE MADE IN ACCORDANCE WITH GENERAL STANDARD ACCOUNTING PROCEDURES, etc. etc.

Operations at each Federal Reserve Bank also are subject to periodic review by the General Accounting Office (GAO), the audit arm of the U.S. Congress. However, *GAO auditors are restricted by law from reviewing monetary policy operations and transactions carried out by the Federal Reserve on behalf of foreign central banks.* Beyond the eyes of objective and independent scrutiny!!

Together with two non-audit groups, the auditing department controls activities in the Bank's gold vault, which stores about one-third of the world's official gold stock (about 12,000 tons - valued at approximately $125 billion at current market prices). Auditors (internal) monitor all gold transactions, both deposits and withdrawals, and independently verify accounting records and balances pertaining to gold being held in custody by the Bank.

 

THE RED BARON

(July - 1997)

Next Week:

Part - II - GOLD PRICE CONTROL BY CENTRAL BANKS