Treasury and Federal Reserve Foreign Exchange Operations
Cross, Sam Y., Federal Reserve Bulletin
Treasury and Federal Reserve Foreign Exchange Operations During the early weeks of the period under review, the dollar continued the generally upward trend that had prevailed throughout the summer, moving higher against all major foreign currencies but especially against the German mark. At times during August and to a lesser extent during September, there were episodes of upward pressure whereupon the U.S. authorities intervened, selling dollars to restrain the dollar's rise. As the period progressed, shifts in expectations about the U.S. economic outlook, about the prospects for further increases in U.S. short-term interest rates, and about the progress of external adjustment led to a more cautious attitude toward the dollar, and the currency started to ease. During October, selling pressures intensified, and late that month the U.S. authorities intervened in the foreign exchange market to support the dollar. On balance, the dollar ended the three-month period about 5 1/2 percent lower against the Japanese yen and 5 percent lower against the German mark from levels at the end of July.
In the opening weeks of the period, the dollar was buttressed by the release of economic statistics indicating continued strength in the U.S. economy. The August 5 announcement of preliminary employment data for July, together with an upward revision to June employment data and evidence of increasing capacity utilization, suggested that U.S. economic growth was proceeding at a pace that could give rise to new inflationary pressures. Market participants interpreted these economic statistics as increasing the likelihood that the Federal Reserve would tighten its monetary policy stance. Some observers already claimed to see signs of Federal Reserve tightening and were attracted by the prospects of rising short-term interest rates and the relatively high yields available on dollar-denominated assets. Even so, market participants were somewhat surprised when the Federal Reserve raised the discount rate 1/2 percentage point to 6 1/2 percent on August 9. Subsequently, short-term interest rate differentials favoring the dollar against both the German mark and the Japanese yen widened. On August 10, the dollar reached its period high of DM1.9245 against the mark while trading as high as Y135.20 against the yen. At that time, the dollar was 2 1/2 percent higher against the mark and 1 1/2 percent higher the yen from the start of the period. From its low point around the turn of the year, the dollar had moved up more than 23 percent against the mark and more than 12 percent against the yen.
For several weeks thereafter the dollar traded firmly as market participants adjusted commercial leads and lags and implemented other hedging strategies to take account of the dollar's renewed strength. Sentiment toward the dollar remained bullish, with traders interpreting even potentially unfavorable news as favorable for the dollar. In these circumstances, market participants questioned the degree of the administration's concern over the dollar's rise.
Perceptions that external adjustment was proceeding on track encouraged positive sentiment toward the dollar. Market participants noted that the trade deficit had narrowed with each of the previous three monthly reports, setting in place a trend of improved performance based on varying combinations of strong export performance and slower growth of imports. The August 16 report that the U.S. trade deficit for June had widened to a seasonally adjusted $12.5 billion from a revised $9.8 billion in May initially disappointed the market, and the dollar briefly declined. But strong upward pressure on the dollar soon re-emerged as some market participants seemed to view the widening of the deficit--and in particular the rise in imports--as yet another indication that the Federal Reserve might further tighten its policy stance to counter inflationary pressures. Meanwhile, others noted the favorable implications for increasing U. …