Treasury and Federal Reserve foreign exchange operations.

This quarterly report describes Treasury and System foreign exchange operations for the period from August through October 1993. It was presented by Peter R. Fisher, Senior Vice President and Manager for Operations of the Federal Reserve Bank of New York. Frank Keane was primarily responsible for preparation of the report.

During the August-October period, the dollar appreciated 3.7 percent against the Japanese yen, depreciated 3.2 percent against the German mark, and was little changed on a trade-weighted average basis, declining 0.4 percent. [1] On August 19, the U.S. monetary authorities purchased $165 million against the yen in the period's only intervention operation.

APPRECIATION AND SUBSEQUENT REVERSAL OF THE YEN AGAINST THE DOLLAR

During early August, the yen strengthened against the currencies of all major industrialized countries, reaching record highs against the dollar, the mark, the Swiss franc, the pound sterling, and the Canadian and Australian dollars. On August 11, the release of data indicating a wider-than-expected expansion of 28 percent (year-on-year) in Japan's merchandise trade surplus to $11.84 billion triggered a sharp yen appreciation, and it traded to a new high against the dollar of yen103.50. Continuing weakness in domestic economic indicators was perceived as evidence that a reduction of Japan's current account surplus was unlikely in the near term, and the yen moved to several new dally highs against the dollar, peaking at a postwar high of yen100.40 on August 17.

From August 16 to 18, conditions in the Japanese money markets were cased. On August 19, the Japanese cabinet met and agreed to try to devise additional measures to stimulate domestic demand. The dollar was trading at yen102.50 in early New York dealing on August 19 but then declined quickly to yen101.35 after the release of data on the U.S. merchandise trade deficit, which, at $12.1 billion for June, was worse than expected; at the same time, the dollar abruptly declined 1 pfennig against the mark. The U.S. monetary authorities intervened shortly after the release of the trade data. During the day, they purchased a total of $165 million against the yen, shared equally between the Federal Reserve and the Treasury's Exchange Stabilization Fund. This operation was coordinated with another monetary authority.

Initially, the operations surprised market participants, and the dollar promptly rose. During the morning, Treasury Under Secretary Summers released a statement welcoming the decline in Japanese money market rates and expressing concern that further yen appreciation could retard growth in the Japanese and world economies. Operations continued after Under Secretary Summers's statement but ceased before noon. Market participants subsequently continued to cover short positions throughout the afternoon, and the dollar reached a high of yen106.75 before closing the day at yen105.95.

In the month after the operation, the dollar-yen exchange rate largely traded between yen103.00 and yen106.00, as market participants increasingly focused on the apparent weakness of the Japanese economy. A series of Japanese data releases showed continued weak business sentiment, deteriorating corporate profits, and a decline of 0.4 percent in second-quarter gross domestic product. Consequently, when the Bank of Japan lowered the official discount rate (ODR) on September 21 by a greater-than-expected reduction of 75 basis points to 1.75 percent, the action was perceived as an appropriate supplement to the government's efforts to stimulate the economy, not as a device to avoid further yen appreciation. Favorable reactions by senior U.S. officials to the Bank of Japan's action led to a perception that tensions between the United States and Japan on trade issues had given way to greater cooperation, and the yen declined about 1.5 percent, closing on September 21 at yen106.18.

The dollar firmed gradually over the latter half of the three-month period, while expectations of near-term volatility in the dollar-yen exchange rate dwindled substantially. The implied one-month option volatility fell from about 14 percent in mid-September to about 10 percent in late October. The period closed with the dollar-yen exchange rate trading steadily above yen108.00 in late October.

APPRECIATION OF THE MARK AGAINST THE DOLLAR IN THE WAKE OF THE ERM CRISIS

The European Community finance ministers and central bank governors agreed, effective Monday, August 2, to permit currencies participating in the Exchange Rate Mechanism (ERM) to fluctuate within 15 percent of their central parities. However, authorities from Germany and the Netherlands agreed to maintain their bilateral exchange rate within 2.25 percent of their central parity. During the uncertainty created by the currency turmoil in Europe, market participants had aggressively accumulated dollar positions in late July. When widely anticipated European interest rate reductions failed to materialize in the first few weeks of August, the mark began to appreciate against the dollar. The negative sentiment toward the dollar during this period was reinforced by market reports of dollar sales by European central banks to adjust reserve positions after July's currency turmoil and by a widening of interest rate differentials in the mark's favor implied by Eurocurrency futures contracts.

The Bundesbank Council's decision on August 26 to leave official rates unchanged disappointed market expectations of an interest rate cut, and banks were caught short of funds at the end of a reserve period. When the council did lower the discount and Lombard rates 50 basis points to 6.25 percent and 7.25 percent respectively on September 9, the concurrent, smaller-than-expected reduction of 10 basis points to 6.70 percent in the Bundesbank's money market repurchase rate led to continued tightness in German money markets. These developments resulted in continued mark strength against the dollar. Although the mid-September political unrest in Russia caused the dollar to appreciate briefly against the mark, the dollar again drifted lower when the crisis was resolved, closing at DMI .6013 on October 13.

On October 21, the Bundesbank Council surprised exchange markets by again reducing its discount and Lombard rates 50 basis points to 5.75 percent and 6.75 percent respectively. The council also announced that it would conduct the following week's fourteen-day repurchase agreement at a fixed rate of 6.40 percent, a reduction of 27 basis points from the previous day's variable-rate repurchase agreement. The dollar, which had begun rising gradually against the mark before the announcement, rose steadily over the remainder of the period, closing at DMI .6857 on October 29.

OTHER OPERATIONS

The Federal Reserve and the Treasury's Exchange Stabilization Fund (ESF) each realized profits of $22.1 million from the sales of Japanese yen in the market. Cumulative valuation gains on outstanding foreign currency balances as of the end of October were $3,368.5 million for the Federal Reserve and $2,839.0 million for the ESE

The Federal Reserve and the ESF regularly invest their foreign currency balances in a variety of instruments that yield market-related rates of return and that have a high degree of liquidity and credit quality. A portion of the balances is invested in securities issued by foreign governments. As of the end of October, the Federal Reserve and the ESF held, either directly or under repurchase agreements, $10,004.3 million and $10,276.6 million respectively in foreign government securities valued at end-of-period exchange rates.

1. The dollar's movements on a trade-weighted basis are measured using an index developed by the staff at the Board of Governors of the Federal Reserve System.

1. Federal Reserve reciprocal currency arrangements

   Millions of dollars

                                                   Amount of
             Institution                           facility,
                                               October 31, 1993
Austrian National Bank  .........................     250
National Bank of Belgium  .......................   1,000
Bank of Canada  ................................    2,000
National Bank of Denmark  .....................       250
Bank of England  ...............................    3,000
Bank of France  ................................    2,000
Deutsche Bundesbank  ..........................     6,000
Bank of Italy  ...................................  3,000
Bank of Japan  .................................    5,000

Bank of Mexico  ................................      700
Netherlands Bank  ..............................      500
Bank of Norway  ................................      250
Bank of Sweden  ................................      300
Swiss National Bank  ............................   4,000

Bank for International Settlements
Dollars against Swiss francs  .....................   600
Dollars against other authorized European
   currencies  ..................................   1,250

Total  ........................................... 30,100

2. Net profits or losses (-) on U.S. Treasury
   and Federal Reserve foreign exchange operations [1]
                                                  U.S. Treasury
                                       Federal     Exchange
      Period and item                  Reserve    Stabilization
                                                     Fund
Valuation profits and losses on
  outstanding assets and liabilities
  as of July 31, 1993  .............   3,226.6      3,005.5

Realized, August 1-
  October 31, 1993  ...............       22.1         22.1
Valuation profits and losses on
  outstanding assets and liabilities
  as of October 31, 1993  ..........   3,368.5      2,839.0
  [1] Data are on a value-date basis.