Academic journal article Federal Reserve Bulletin

Treasury and Federal Reserve Foreign Exchange Operations

Academic journal article Federal Reserve Bulletin

Treasury and Federal Reserve Foreign Exchange Operations

Article excerpt

This quarterly report, covering the period November 1990 through January 1991, provides information on Treasury and System foreign exchange operations. It was presented by Sam Y. Cross, Manager of Foreign Operations of the System Open Market Account and Executive Vice President in charge of the Foreign Group of the Federal Reserve Bank of New York. Daniel H. Brotman was primarily responsible for preparation of the report. (1)

The dollar was subjected to conflicting forces during the November-January period. Sentiment toward dollar investments continued to deteriorate as the U.S. economy weakened and as interest rate differentials moved further in favor of foreign currencies. But at times, political developments abroad-particularly the Persian Gulf conflict-encouraged greater demand for dollars and limited the extent to which negative sentiment toward the currency was reflected in exchange rates. With these offsetting factors helping to maintain a sense of two-way risk to dollar exchange rates, the dollar ended the period mixed against major foreign currencies, and the U.S. monetary authorities conducted no intervention operations in the foreign exchange market. The dollar closed the period down slightly against the German mark and up slightly against the Japanese yen. On a trade-weighted basis, as measured by the staff of the Board of Governors of the Federal Reserve System, the dollar ended the period I percent below its level at the beginning of the period.


In the early part of the period, market attention centered on evidence of diverging growth and interest rate trends in the major industrial economies. Ever since the Iraqi invasion of Kuwait in August and the associated rise in oil prices and decline in consumer confidence, analysts had been progressively revising downward their forecasts for U.S. economic growth. The release of October payroll employment data in the first week of November revealed an unexpectedly large drop that, together with subsequent data, reinforced the view that the U.S. economy was slowing down. At the same time, preliminary indications suggested that inflationary pressures were subsiding. Under these circumstances, market participants widely expected that the Federal Reserve would continue to ease money market conditions and possibly reduce its discount rate.

In contrast, market forecasts for the German and Japanese economies remained relatively upbeat. The need to rebuild East Germany was seen as providing ongoing stimulus to the German economy. Japanese economic data provided little evidence that the economy or price pressures were slowing in response to the central bank's tight policy stance. Mindful of these economic trends, market participants expected that German and Japanese interest rates would either rise further or would remain at existing levels. Indeed, on the first day of the period, the Bundesbank announced an increase of 1/2 of 1 percentage point in its official Lombard rate, and many market participants expected further tightening after German national elections in early December. The Bank of Japan was considered less likely than the Bundesbank to tighten monetary policy but was nonetheless seen as unwilling to ease monetary conditions, given high oil prices and Japan's tight labor market conditions.

The divergent outlook for interest rates weighed on the dollar in early to mid-November. Short-term interest rate differentials had been steadily moving against the dollar since spring 1989, when dollar investments held an interest rate advantage of 4 to 6 percentage points relative to the mark and yen. By late summer 1990, the dollar's short-term interest rate advantage had been entirely eliminated. Thus, in early November, expected further declines in dollar interest rates, coupled with steady to higher rates abroad, threatened to push short-term U.S. interest rates well below mark and yen rates for the first time since 1980. …

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