Treasury and Federal Reserve foreign exchange operations.

This quarterly report, covering the period November 1992 through January 1993, provides information on Treasury and System foreign exchange operations. It was presented by William J. McDonough, Executive Vice President of the Federal Reserve Bank of New York and Manager of the System Open Market Account. John W. Dickey was primarily responsible for preparation of the report(1).

During the November-January period, the dollar continued to appreciate against the German mark and Japanese yen from the low levels established in the prior period. The U.S. authorities did not intervene in the foreign exchange markets.

Developments in Dollar

Exchange Markets

Over the period, the dollar gained 1 percent in value against the yen, 4.5 percent against the mark, and 5.5 percent on a trade-weighted basis(2). The dollar's upward movement was supported, first, by the perception that the incoming Clinton Administration would pursue a policy of fiscal stimulus and, subsequently, by stronger-than-expected U.S. economic growth and persistent expectations of official rate reductions in Germany and Japan. The dollar's trend was interrupted by changing estimates of the amount of any U.S. fiscal stimulus, by perceived postponements of German rate reductions, and by widespread market reports of European central bank sales of dollars.

The Dollar Trends Higher

After the U.S. election in November, analysts were predicting that the U.S. economy would begin to outperform those of other industrialized countries and that a narrowing of interest rate differentials would favor the dollar in the coming year. The prospect of a strengthening dollar was given continued support by indications that President-elect Clinton would apply fiscal stimulus early in 1993 should there be any sign of economic weakness. Although hopes for a reduction in official rates by the Bundesbank were disappointed in both November and December, expectations for such a move early in the year persisted. Anticipating a stronger dollar in the year, market participants in late December and early January bid up the dollar to its period highs of DM1.6490 on January 8 and [yen]126.21 on January 13.

After mid-January, however, there was an unwinding of long-dollar positions as it became apparent that a reduction in official rates by the Bundesbank was not imminent and that the Clinton Administration's overall fiscal policy might put greater weight on reducing the budget deficit. Many market participants then assumed that if U.S. economic conditions were to worsen, responsibility for ensuring adequate economic growth would fall on the Federal Reserve. Although a reduction in official U.S. rates was still not seen as likely, an easing was perceived to be in the range of possible monetary policies, and that perception contributed to the dollar's brief reversal. But at the end of January, the release of stronger-than-expected U.S. economic data, particularly the strong fourth-quarter 1992 gross domestic product and December 1992 durable goods orders, seemed to erase the prospects for interest rate reductions by the Federal Reserve and refresh the expectation that the U.S. economy would be outperforming others over the year. Thus, in the closing days of the period, the dollar moved up from January lows of DM1.5660 and [yen] 122.85 to close the period at DM1.6102 and [yen] 124.60.

The Market Awaits Interest Rate Reductions

in Germany and Japan

Throughout the period, on-again, off-again expectations for reductions in official interest rates by the Bundesbank and the Bank of Japan punctuated the dollar's movements.

In response to continued pressures within the European exchange rate mechanism (ERM), many market participants expected that the Bundesbank would ease interest rates in early November, and, when this did not occur, attention focused on the prospects for an easing in December. Although no official rate reduction came in December, the Bundesbank's market operations were designed to avoid end-of-year upward pressure on interest rates. Moreover, in statements that appeared to acknowledge a weakening in the German economy while expressing optimism about the central bank's ability to control inflation, senior Bundesbank officials predicted sharp reductions in German interest rates during the course of 1993. In the final week of December, Bundesbank official added that an easing could occur earlier in 1993 than was previously expected. During this period, the dollar posted most of its gains toward its January 8 high against the mark.

In early January, the Bundesbank did engineer a small reduction in market interest rates through its market repurchase operations. However, by mid-January, when the decline in market rates had not been followed by a reduction in the Bundesbank's official discount and Lombard rates, expectations were that an easing in German monetary policy would be postponed until early March, and the dollar began its brief reversal against the mark.

Expectations of a reduction in the official discount rate (ODR) by the Bank of Japan persisted during the period, gaining in strength as the period closed, although with less direct effect on exchange rates than in the German case. In December, comments by Japanese officials focused on the need to stimulate demand through fiscal policy, and, as a result, prospects for a cut in the ODR receded. But in January, the release of weak Japanese retail sales, production, and employment data and a declining stock market heightened concerns about weakness in the Japanese economy and returned attention to the prospects for an immediate reduction in the ODR. Despite widespread expectations for an ODR cut at the end of January, the dollar was not able to sustain its mid-January high against the yen as exchange market attention focused on the January 22 report of a record Japanese trade surplus for the calendar year 1992 and on the risk that policymakers might respond to the trade imbalance by seeking an appreciation of the yen.

Currency Tensions in Europe Continue

Pressures on several European exchange rates, particularly the German mark-French franc rate, persisted during the November-January period. In response to these pressures, German and French authorities repeatedly stated their commitment to the existing parity between their currencies and confirmed their participation in market intervention in support of the franc. The Spanish peseta and the Portuguese escudo were each devalued within the ERM 6 percent on November 22, and Irish punt was devalued 10 percent on January 30. In addition, the Swedish and Norwegian monetary authorities abandoned their currencies' links to the European currency unit on November 19 and December 10 respectively.

Although these exchange rate pressures within Europe had little direct impact on dollar exchange rates, particularly in comparison with the previous period, transactions related to the financing of official European intervention were perceived as affecting the dollar. Throughout the period, market participants reported that both in the course of rebuilding official reserves and in transactions related to financing official borrowings, several European central banks were heavy sellers of dollars and that, at times, this selling pressure restrained the dollar's upward trend against the mark.

Although the U.S. authorities did not execute any foreign exchange transactions during the period, settlements were completed on a total of $1,455.8 million in forward sales of German marks. As previously reported, these settlements were executed in May 1992 with the Deutsche Bundesbank in an effort by both the U.S. and German monetary authorities to adjust the level of their respective foreign currency holdings. During the period, $729.4 million and $726.5 million against marks settled on November 23 and December 21 respectively, completing the total $6,176.6 million of spot and forward dollar purchases from the Bundesbank. For each transaction, 60 percent was executed for the account of the Federal Reserve and 40 percent for the account of the Treasury's exchange stabilization fund (ESF). The Federal Reserve and the ESF realized profits of $109.5 million and $25.1 million respectively from these settlements. As of the end of January, cumulative valuation gains on outstanding foreign currency balances were $2,868.4 million for the Federal Reserve and $1,749.9 million for the ESF.

The Federal Reserve and the ESF invest their foreign currency holdings in a variety of instruments that yield market-related rates of return and 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 January, the Federal Reserve and the ESF held either directly or under repurchase agreements $7,834.0 million and $8,356.0 million equivalent respectively in foreign government securities valued at end-of-period exchange rates.

1. Federal Reserve reciprocal currency arrangements

  Millions of dollars
                                         Amount of
              Institution                 facility,
                                      January 31, 1993

Australian 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 of International Settlements
Dollars against Swiss francs                  600
Dollars against other authorized European
  currencies                                1,250

Total                                      30,000

2. Net profits of losses (-)
on U.S. Treasury and Federal Reserve
foreign exchange operations(1)

  Millions of dollars
                                                 U.S. Treasury
         Period and item               Federal    Exchange
                                       Reserve   Stabilization
                                                    Fund

Valuation profits and losses on
  outstanding assets and liabilities
  as of October 31, 1992               3,746.3    2,293.8

Realized, October 31, 1992-January
  31, 1993                               109.5       25.1
Valuation profits and losses
  on outstanding assets
  and liabilities as of
  January 31, 1993                     2,868.4    1,749.9

(1.) Data are on a value-date basis.

(1.) The charts for the report are available from Publications Services, Board of Governors of the Federal Reserve System, mail stop 138, Washington, DC 20551. (2.) The dollar's movement on a trade-weighted basis are measured using an index developed by the staff of the Board of Governors of the Federal Reserve System.