Treasury and Federal Reserve Foreign Exchange Operations

Article excerpt

This report, presented by Peter R. Fisher, Executive Vice President, Federal Reserve Bank of New York, and Manager, System Open Market Account, describes the foreign exchange operations of the U.S. Department of the Treasury and the Federal Reserve System for the period from October 2000 through December 2000. Ryan Faulkner was primarily responsible for preparing the report.

During the fourth quarter of 2000, the dollar appreciated 5.7 percent against the yen and depreciated 6.4 percent against the euro. On a trade-weighted basis, the dollar ended the quarter 1.0 percent weaker against an index of major currencies. Movements in the major currency pairs were largely influenced by changes in market expectations for economic growth in the United States, Europe, and Japan. Questions about the pace of Japan's economic recovery pressured the yen against the major currencies, while the dollar declined against the euro in December amid signs of slower U.S. growth. U.S. monetary authorities did not intervene in the foreign exchange markets during the quarter.

MARKET REACTION TO CHANGING GLOBAL ECONOMIC GROWTH TRENDS

During the fourth quarter, releases of economic data in the United States indicated continued low inflation and a slowdown in the pace of U.S. economic growth. Earlier in the quarter, market participants had expected a steady near-term U.S. interest rate policy, given the price pressures emanating from high energy prices and tight U.S. labor markets. On November 15, the Federal Open Market Committee (FOMC) left the target federal funds rate unchanged at 6.5 percent and maintained its statement that the balance of risks was weighted toward inflationary pressures.

By early December, however, there was a sharp downward shift in U.S. interest rate expectations, prompted by (1) increasing signs of slower U.S. growth, (2) comments by Federal Reserve Chairman Alan Greenspan that were interpreted as suggesting the possibility of lower rates, and (3) weaker financial market conditions. Among the economic data released during this period were weaker-than-expected third-quarter GDP data (advance release), November consumer confidence and National Association of Purchasing Managers (NAPM) surveys, October durable goods data, and November retail sales figures. As expectations for more moderate growth solidified, many market participants also continued to lower their U.S. earnings forecasts. During the fourth quarter, the S&P 500 and Nasdaq Composite equity indexes, on balance, fell 8.1 percent and 32.7 percent, respectively, with some of their sharpest daily losses occurring in December.

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From November 28 to the end of the quarter, the implied yield on the March federal funds futures contract declined 40 basis points to 6.0 percent. Over the same period, the yields on the two-year Treasury note and thirty-year Treasury bond fell 76 and 24 basis points, respectively, leading the two- to thirty-year coupon curve to return to a positive spread for the first time since January 2000. On December 19, the FOMC left its target for the federal funds rate unchanged, while moving its assessment of the balance of risks away from inflationary pressures and to one "weighted toward conditions that may generate economic weakness."

In Europe, expectations for further interest rate increases moderated over the period, in response to signs of slower euro-area growth, the recovery of the euro's exchange value, and a decline in oil prices. At the outset of the quarter, on October 5, the European Central Bank (ECB) raised its minimum bid on its refinancing operations 25 basis points to 4.75 percent. In the press conference that followed the rate announcement, ECB President Duisenberg explained that the rate hike was aimed at containing inflationary pressures "stemming from oil prices and the foreign exchange rate of the euro." After this decision, market participants were divided over the possibility of additional rate hikes by the ECB. …