Foreign Exchange Operations and the Federal Reserve
Broaddus, J. Alfred, Jr., Goodfriend, Marvin, Economic Quarterly - Federal Reserve Bank of Richmond
The operations of U.S. government agencies in foreign exchange markets are probably regarded as arcane by most Americans. These operations are, however, an important element of U.S. international economic policy. And from time to time they are highly visible to the public: for example, when the United States and other major industrial countries intervene jointly in the markets to influence exchange rates, or when they provide assistance to particular countries such as the substantial aid extended to Mexico in 1995.
The Gold Reserve Act of 1934 gives the Treasury primary responsibility for United States foreign exchange operations through its Exchange Stabilization Fund (ESF). Although the Federal Reserve (Fed) had been active in foreign exchange markets in the 1920s and early 1930s, its involvement ceased after 1934.1 There was relatively little need for official U.S. foreign exchange operations in the early post-World War II period. Under the Bretton Woods arrangements of 1944, foreign governments assumed responsibility for fixing the value of their currencies against the dollar. For its part, the United States managed its monetary policy in accordance with the Gold Reserve Act so as to maintain the dollar's convertibility into gold at $35 an ounce.
U.S. authorities, however, were reluctant to pursue sufficiently tight monetary policy to protect the country's gold reserves following the resumption of full convertibility among the major currencies in the late 1950s. And the Fed resumed foreign exchange operations in 1962, after a nearly 30-year hiatus, to supplement and substitute for monetary tightening in defense of the dollar. Although the Fed has consistently held that it has independent authority to undertake foreign exchange operations, in practice the Fed works closely with the Treasury in conducting them. Indeed, the Federal Open Market Committee's (FOMC's) foreign currency directive requires that these operations be conducted "in close and continuous consultation and cooperation with the United States Treasury."2 So it seems fair to say that the Fed recognizes the Treasury's preeminence in foreign exchange policy.
The Treasury welcomed the Fed's renewed participation in large part because the Fed brought with it resources to supplement those of the ESF. In 1962 the Fed established reciprocal currency agreements-commonly called "swaps"-with nine central banks and the Bank for International Settlements. Further, in 1963, the Fed agreed to "warehouse" foreign currencies held by the ESF. The primary objective of these initiatives was to provide U.S. authorities with a supply of foreign currencies to buy back dollars in order to help protect U.S. gold reserves.3
FOMC discussions at the time made it clear that some Fed officials recognized how following the Treasury's lead in foreign exchange operations could compromise the Fed's independence in conducting monetary policy.4 This risk did not present serious operational problems at the time, however, because the United States was committed to the Bretton Woods arrangements and monetary policy was committed to defending the dollar.5 Thus, the Fed and the Treasury were working toward the same general objectives, and the Fed's independence was not a pressing issue in practice.
We argue below that subsequent developments have undermined the favorable conditions that enabled the Fed to participate in foreign exchange operations without compromising either its independence or its monetary policy goals. We make our case by developing several preliminary points. In Section 1 we explain how theoretical advances and practical experience in recent years teach that the Fed's longer-term low-inflation objective must be credible if the Fed is to pursue this objective efficiently via monetary policy. Moreover, the Fed's independence is the cornerstone of this credibility. In Section 2 we explain why Fed credibility based on independence is inherently fragile, and we emphasize the crucial importance of the Fed's off-budget status in supporting its independence. …