The Federal Reserve System, often referred to simply as “the Fed,” is one of the most powerful financial institutions in the world. Created over a century ago in response to recurring financial crises, its mission has evolved over time. While it was intended to stabilize the U.S. financial system, the Fed’s track record, particularly when it comes to maintaining the stability of the U.S. dollar is the subject of ongoing debate and criticism.

Why Was the Federal Reserve Created?

Before the Federal Reserve’s establishment in 1913, the U.S. banking system was fragmented, unstable, and prone to periodic financial panics. The most notable example was the Panic of 1907, a severe banking crisis that nearly collapsed the U.S. financial system. Without a central bank to act as a lender of last resort, private financiers like J.P. Morgan personally intervened to stabilize markets, a situation that policymakers agreed was unsustainable.

Congress created the Federal Reserve through the Federal Reserve Act of 1913 to address several key issues:

• Provide a more elastic currency that could expand, or contract based on economic needs.
• Serve as a lender of last resort to banks in times of financial distress.
• Oversee and regulate the banking system to reduce the risk of financial panics.
• Facilitate a smoother, more efficient national payments system.

Originally, the Fed was not tasked with directly managing inflation or employment — those mandates came years later.

What Does the Federal Reserve Do Today?

Today, the Fed’s responsibilities have broadened considerably. Its modern-day mandate, codified by Congress, is often summarized as the “dual mandate”:

• Promote maximum employment
• Maintain stable prices (inflation control)

In practice, the Fed also pursues financial system stability and moderates long-term interest rates. To do this, the Federal Reserve:

• Sets short-term interest rates (through the federal funds rate)
• Conducts open market operations (buying and selling government securities)
• Regulates and supervises banks
• Issues the U.S. dollar
• Acts as a clearinghouse for financial transactions
• Serves as a lender of last resort in times of crisis (as it did during the 2008 financial collapse and the 2020 COVID-19 pandemic)

The Fed’s tools, particularly its control over interest rates and money supply, give it enormous influence over the economy’s direction.

Why Has the Fed Struggled with Dollar Stability?

Though tasked with maintaining a stable dollar, the Federal Reserve has arguably done a poor job at preserving the purchasing power of the U.S. currency over the long term.

A Century of Dollar Decline

Since the Fed’s founding in 1913, the U.S. dollar has lost over 96% of its purchasing power. What a dollar could buy in 1913 would require more than $30 today. Much of this erosion has been the result of persistent inflation — a phenomenon that the Fed was supposed to guard against.

While a mild, predictable inflation rate is often considered healthy for economic growth, periods of high inflation — notably in the 1970s and early 1980s, and more recently after 2021, have had a destabilizing impact on the economy and diminished the value of savings.

Some economists argue that while the dollar buys less today, living standards, productivity, and wages have also risen over time. Technological progress and higher incomes have offset much of the burden of inflation. However, the benefits of that progress aren’t necessarily evenly distributed.

For savers and retirees relying on fixed incomes or dollar-denominated savings, inflation acts like a stealth tax, slowly eroding wealth. Asset holders (stocks, real estate, commodities) tend to fare better because their assets appreciate over time with inflation.

The Abandonment of the Gold Standard

For much of its early history, the dollar was tied to gold, which helped limit inflation and maintain currency stability. This changed in 1971 when President Richard Nixon ended the dollar’s convertibility to gold, severing the last direct link to a physical commodity.

Since then, the dollar has been a fiat currency, its value is backed only by government decree and market confidence. This gave the Fed broader discretion to manage the money supply and interest rates, but it also removed a key constraint against inflation.

It can be argued that it’s a track record of mismanagement: lower rates too long, ignoring asset bubbles, denying inflation risks, and then scrambling with drastic, market-roiling rate hikes when things go wrong.

It’s also important to note: the dollar was far more stable when it was tied to gold.  The end of the gold standard in 1971 gave the Fed essentially unchecked power to create money out of thin air and some believe they’ve wielded that power with reckless abandon.

Unlike elected officials, the Fed faces no direct consequences for its failures, yet wields enormous power without the constraint of a monetary standard.

Monetary Expansion and Asset Bubbles

In response to financial crises (2008, 2020), the Fed aggressively expanded the money supply through quantitative easing and ultra-low interest rates. While these policies may have prevented immediate economic collapses, they also contributed to:

• Inflated asset prices (stocks, real estate, bonds)
• Rising wealth inequality
• Long-term inflationary pressures now being felt in the 2020’s

Many critics argue that this monetary expansion, combined with persistent deficit spending by the federal government, has undermined the dollar’s stability both at home and abroad.

Dr. Milton Friedman argued the following:

“Inflation is always and everywhere a monetary phenomenon.

The mistake made by people on all sides is to believe that somehow or other, the Fed has been a source of stability. It has not. It has been a major source of instability. 

The history of fiat money is the history of excess, inflation, and financial collapse. 

The Government has three primary ways of controlling the economy: spending, regulation, and control of the money supply. The control of the money supply is by far the most dangerous because it can be done secretly, without anyone realizing what is happening.  Inflation is the one form of taxation that can be imposed without legislation.”

The Federal Reserve was created to stabilize a fragile financial system, and it has succeeded in averting complete financial collapse multiple times. Yet, its broader record on preserving the value and stability of the U.S. dollar is far more questionable.

The dollar’s long-term decline in purchasing power, periods of runaway inflation, and increasing dependence on monetary intervention have raised legitimate concerns about the Fed’s role and effectiveness.  As inflation once again became a central issue to the average American’s life, debates about the future of the Federal Reserve, and whether its structure and mandate still serve the public good are worth having.   And discussions around returning to the gold standard, or some form of a monetary standard should be part of the discussion.

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Much of the news in the recent headlines has been on the topic of the tariffs imposed by President Trump on the imports from foreign nations which has caused a good degree of market volatility.

A tariff is simply a tax imposed by a government on goods and services imported from other countries, essentially increasing the price of those imported goods and services.   As a result, the concern is that additional tariffs will add to inflation.   Whether or not this is true remains to be seen.   Historically inflation has been more of a function of the money supply.   As we saw in 2021, the M2 money supply grew by a staggering 40% in just 18 months as a result of the policies of the Covid response, and inflation accelerated quickly.

Remember that in 2018 we saw similar tariffs imposed during the 1^st Trump administration, and no such inflation occurred.   The reason for this is likely because the motivation of the President’s position was not consistent with what occurred in 1930 with the Smoot-Hawley Tariff Act.

At that time, during the early stages of the Great Depression, the motivation was to limit free trade in an attempt to protect American industries.  The thought was this would boost domestic production and employment.  However, limiting free trade does not in fact protect American industry, but rather harms it.   The reason is every nation has something it does better than others.   The best way to grow both domestic and global commerce is to have goods and services produced in the most efficient way possible, which may mean that in some cases they are produced in the USA, and in some cases not.

However, what is free trade?  Free trade is a policy position that does not restrict imports or exports.   The question is whether or not the USA has been engaging in free trade with its global trading partners.    Looking at the chart above which shows the average tariff rate imposed by each nation, we can see that it is tough to argue that we have had a level playing field in terms of global trade for quite some time.   While the USA has historically imposed 3.3% on average, the European Union has imposed a 50% higher tariff rate.   India has been the worst offender among our global trade partners at 17%, which is more than 5 times the rate the USA has imposed.  This begs the question, is this actually free trade?

This has contributed to a perpetually growing US trade deficit with most of the world.  A trade deficit occurs when a nation imports more than it exports.  The fundamental cause of a trade deficit is an imbalance between a country’s savings and investment rates.  The reason for the deficit is the United States as a whole spending more money than it makes, which results in a current account deficit.  That additional spending must, by definition, go towards foreign goods and services.  Financing that spending happens in the form of either borrowing from foreign lenders (which adds to the U.S. national debt) or foreign investing in U.S. assets and businesses—the capital account.

However, in a true free market economy, trade deficits should swing back and forth between nations rather than moving consistently in one direction.   There are many things that lead to a trade deficit.   Some of the other causes that contribute to a trade deficit beyond tariffs are as an example:

More government spending, if it leads to a larger federal budget deficit, reduces the national savings rate and raises the trade deficit.

The exchange rate of the dollar is important, as a stronger dollar makes foreign products cheaper for American consumers while making U.S. exports more expensive for foreign buyers.

A growing U.S. economy also often leads to a larger deficit, since consumers have more income to buy more goods from abroad.

The data in the above chart is what the current administration seeks to change.  What is important to point out is that the stated intent is not to create a protectionist economic environment similar to 1930, but rather to level the playing field.  The question is…will the current administration be successful in any meaningful way?  That remains to be seen.

Perhaps they will be successful with some nations and not others.   At this early stage, that can’t be known.    However, what we can see below is that the same nations are generally much more dependent on exports as a share of their GDP than the United States, which is why the current administration believes they are negotiating from a position of strength.

As a result, the current administration believes that they can get other nations to lower their barriers to entry for USA exports.    Time will tell if that happens.  We have already seen some nations respond with a willingness to renegotiate, while others have imposed retaliatory tariffs.

If you put yourself in the position of an opposing politician, it can be difficult to immediately cut a deal with the administration because it may make you look weak, and harm you politically.   It’s likely that many of the opposing hardline positions will soften in the coming weeks as the story leaves the headlines.

What does all this mean for markets?  Not surprisingly, this has led to a quick decline in stocks as markets digest the possible impact to corporate earnings, and companies consider possible changes to their business strategy.   However, at this point the decline, while unpleasant, is well within the range of historical market corrections and nothing unusual to date.

More importantly, other assets classes, such as fixed income are serving to buffer the volatility quite well, as the Barclays Aggregate Bond Index is positive approximately 3.50% year to date as of this moment.    That is a bright spot in the recent volatility which suggests that while market declines are not fun, markets are functioning quite normally.   In contrast, during the 2008 Financial Crisis, and the beginning of the Pandemic of 2020 the bond market declined rapidly along with stocks as the market experienced a liquidity crisis, leaving investors nowhere to hide.   That is not happening at the moment, and the conservative arm of investor portfolios is doing exactly what it is supposed to do.

While we can’t tell you where the bottom of this particular downturn will be, we can say that there will be a bottom, and trying to time such events is as always, an exercise in futility.   Eventually other nations will come to terms with the United States on aggregable tariffs rates for both sides, and we will see how much the terms change in favor of the USA, if at all.

In the meantime, the best answer is the same answer as in any other downturn, and that is to stick to your financial plan, as this period will also pass.

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