Treasury and Federal Reserve foreign exchange operations.

This quarterly report describes Treasury and System foreign exchange operations for the period from October through December 1994. It was prepared by Peter R. Fisher, Executive Vice President, Federal Reserve Bank of New York, and Manager for Foreign Operations, System Open Market Account. Carol Osler was primarily responsible for preparation of the report.(1)

During the fourth quarter of 1994, the dollar fell 0.1 percent against the German mark but rose 0.5 percent against the Japanese yen and 1.0 percent on a trade-weighted basis.(2) On November 2, the U.S. monetary authorities purchased $800 million against the German mark and an equal amount against the Japanese yen, and Treasury Secretary Lloyd Bentsen issued a statement affirming the Administration's support for a stronger dollar. On November 3, the U.S. monetary authorities intervened again, this time purchasing $500 million against the German mark and an equal amount against the Japanese yen. In other operations, the US. and Mexican monetary authorities activated their $6 billion swap facility after Mexico announced, before the market opened on December 22, that the peso would be allowed to float.

THE DOLLAR DECLINES DURING OCTOBER

Having closed the previous period at DM1.5510, the dollar traded fairly steadily against the German mark. Against the Japanese yen, the dollar rose briefly from 99.10[yen], its close at the end of the previous quarter after a partial trade agreement between the United States and Japan was announced on October 1. Soon thereafter, however, the dollar started to decline against both currencies.

Early in the period, continued signs of robust growth in the U.S. economy led market participants to question the Federal Reserve's decision not to raise rates at its September 27 meeting, and concern that the stance of monetary policy was inadequate to contain price pressures began to grow. At the same time, market participants perceived short-term and long-term US. rates as too low relative to comparable foreign rates and found in these differentials an explanation for the dollar's weakness during the year and a reason for further dollar weakness.

Against the mark, the dollar started to decline sharply on October 13. This decline occurred as expectations rose that the coalition government of Chancellor Helmut Kohl would be returned to office in Germany's October 16 federal elections and as German bond and stock markets rallied. The dollar's downward movement accelerated as it breached a number of important technical points. From its closing level of DM1.5405 on October 12, the dollar fell to DM1.4937 on October 17. After this abrupt decline, market discomfort with the level of U.S. interest rates grew more pronounced and market participants began to express the view that the U.S. Administration was becoming less concerned about the dollar. At the same time, the dollar also began to decline against the yen, particularly as a result of heavy dollar sales by Japanese exporters.

By October 25, the dollar had declined to 96.40[yen and a period low of DM1.4860. The release on October 28 of gross domestic product data containing encouraging news about the U.S. price deflator provided a brief respite, but as November began, pressure on the dollar intensified once again.

U S. MONETARY AUTHORITIES ENTER THE MARKET TO BUY DOLLARS AGAINST THE MARK AND THE YEN

On the morning of Wednesday, November 2, the dollar fell to a new postwar low of 96.11[yen] and was trading at DM1.4910. Shortly after 11:00 a.m., the Federal Reserve Bank of New York's Foreign Exchange Desk entered the market, purchasing dollars for the U.S. monetary authorities. During the course of the day, the Desk purchased $800 million against the mark and $800 million against the yen.

As the intervention began, Treasury Secretary Bentsen issued the following statement:

I believe that recent movements in the dollar are inconsistent with the fundamentals of a strong investment-led recovery in the United States and the greatly enhanced ability of U.S. firms to compete around the world. This Administration is committed to sound economic policies that expand the economy's capacity and sustain recovery with low inflation. Continuation of recent foreign exchange trends would be counterproductive for the United States and the world economy. A stronger dollar will reduce inflation pressures, improve American living standards, and promote investment. We will continue to monitor developments closely in cooperation with our G-7 (Group of Seven) partners.

Later that day Bundesbank President Hans Tietmeyer expressed support for the U.S. operation, saying "I welcome the fact that the American monetary authorities have clearly expressed their interest in a stronger dollar and want to back this with an appropriate policy. This statement (by Secretary Bentsen) is likely to contribute to bringing the value of the dollar on markets more into line with the fundamental data." After reaching intra-day highs of DM1.5220 and 98.00[yen], the dollar closed at DM1.5149 and 97.60[yen].

Shortly after 11:00 a.m. on Thursday, November 3, with the dollar trading at DM1.5145 and 97.65[yen], the Desk intervened a second time on behalf of the US. monetary authorities. During the course of the day, the Desk purchased $500 million against the mark and $500 million against the yen. The dollar reached intraday highs of DM1.5260 and 98.30[yen] before closing at DM1.5185 and 97.73[yen].

On both days of intervention, the yen operations of the U.S. monetary authorities were coordinated with the operations of the monetary authorities of another country. All the dollar purchases of the U.S. monetary authorities were divided equally between the Federal Reserve and the Exchange Stabilization Fund (ESF) of the Department of the Treasury.

THE DOLLAR CONTINUES TO STRENGTHEN DURING NOVEMBER

After the intervention, the dollar continued to rise against the mark as market participants became increasingly confident that the Federal Reserve would raise official U.S. interest rates at the November 15 meeting of the Federal Open Market Committee (FOMC). On November 9, in Asian and early European trading hours, the dollar rose abruptly in response to the results of the previous day's U.S. elections, in which the Republican party took control of both the House and the Senate. From its closing levels the day before, the dollar rose nearly two pfennigs to DM1.5265 and about half a yen to 97.70[yen] by the time the New York market opened on November 9, then traded around these levels for the rest of the day.

By the eve of the November 15 FOMC meeting, the dollar had risen further, reaching DM1.5441 and 98.28[yen]. In the event, the Federal Reserve's decision to raise the federal funds and discount rates 75 basis points surprised many market participants, who had generally expected the Federal Reserve to raise rates only 50 basis points. The dollar spiked higher in response. The perceived aggressiveness of the action also encouraged some market participants to anticipate additional tightening in December.

The dollar's rally continued through the end of November, as the notable widening of short-term interest rate differentials encouraged market participants to accumulate dollar positions. Market behavior began to reflect the perception that the Federal Reserve would bring short-term interest rates to levels that were high enough to restrain incipient inflationary pressures. Indeed, the dollar rose on stronger-than-expected U.S. data on consumer confidence, third-quarter GDP, and November nonfarm payrolls. Market participants also came to view U.S. rates as sufficiently high to compensate investors for the continued risk of dollar decline. For example, three-month U.S. rates, which had only moved above equivalent German rates in September, had come to surpass German rates by about 100 basis points. For foreign exchange market participants, the stability and subsequent decline of long-term U.S. bond yields during late November also helped to support the dollar because these developments suggested good demand for long-term U.S. paper. The dollar closed the month at DM1.5692 and 98.90[yen], up 4.4 percent and 2.1 percent respectively over its values at the end of October.

THE DOLLAR TRADES QUIETLY AGAINST THE MARK AND YEN DURING MOST OF DECEMBER

The dollar's rise came to an end in early December and, with the volume of transactions reduced by the holiday season, the currency traded for most of the month around the DM1.57 and 100 levels. Expectations among some market participants that the Federal Reserve would raise interest rates in late December--a view partly based on Chairman Greenspan's December 7 testimony before Congress, in which he characterized US. growth as stronger than expected--helped support the dollar. At the same time, however, strong German GDP data for the third quarter and volatility in U.S. interest rate markets, caused by the liquidation of the financing positions of the Orange County investment pool and of other portfolios, appeared to limit the dollar's upside. At its December 20 meeting, the Federal Reserve left U.S. interest rates unchanged, a decision that had no immediate impact on the dollar. By the end of the period, however, the dollar was nearly three pfennigs and about half a yen lower, with most of the decline coming on December 28 in thin market conditions. The dollar closed the quarter at DM1.5490 and 99.55[yen].

THE CANADIAN DOLLAR DECLINES STEADILY

After opening at C$1.3450, the Canadian dollar weakened steadily against the U.S. currency and finished the quarter at C$1.4025, down 4.2 percent. International investors were discouraged from purchasing Canadian dollars by short-term interest rate differentials that, for much of the period, favored the U.S. currency, especially after the mid-November rise in US. short-term rates. These investors also expressed concern about large Canadian government budget deficits at the federal and provincial levels, and about political uncertainty stemming from Quebec's quest for sovereignty.

MEXICAN AUTHORITIES ALLOW THE PESO TO FLOAT

Over the quarter, the peso declined 30 percent against the dollar from its initial level of 3.3930 new pesos (NP) per dollar. The move began as a gradual depreciation within the permissible range set by the government. The peso remained within its band through November and for a few weeks past President Zedillo's December 1 inauguration, despite considerable financial market pressures and increasing concern among market participants about possible inconsistencies within the Mexican economic strategy. The view increasingly took hold that, even at the lower limit of the band, the peso was overvalued given Mexico's past inflation and a current account deficit estimated at nearly 8 percent of the country's GDP. Nevertheless, investors remained hopeful that Mexico would not ultimately be required to change its exchange rate policy.

From the start of the quarter through Monday, December 19, the peso declined 2 percent to reach 3.4632. On the morning of December 20, the Mexican financial authorities, in agreement with representatives of labor and business, changed the peso's lowest permissible value against the dollar by 0.53 pesos, to NP4.0016 from NP3.4712 the previous day. Market participants reacted negatively, and the peso was quickly pushed to its new limit. The peso's value against the dollar dropped 12.5 percent on the day. With pressure on the peso continuing unabated, the Mexican financial authorities announced before the market opened on December 22 that "the supply and demand for currency would freely determine the exchange rate until the exchange market stabilized." It was also announced that Mexican and U.S. monetary authorities had jointly activated a pre-existing swap facility of $6 billion. The peso closed the day at NP4.70, 15.7 percent below its close on December 20.

During the rest of December the peso remained volatile as foreign investors continued to reduce their peso exposure. The peso closed the year at NP4.85 per dollar.

TREASURY AND FEDERAL RESERVE FOREIGN EXCHANGE RESERVES

The U.S. monetary authorities intervened twice during the period, purchasing a total of $2,600 million against German marks and Japanese yen. This amount was divided equally between the Federal Reserve and the Treasury Department's Exchange Stabilization Fund (ESF). The Federal Reserve and the ESF realized profits of $313.7 million and $270.9 million respectively on this intervention activity. These profits are based on historical cost-of-acquisition exchange rates.

At the end of the period, the current values of the foreign exchange reserve holdings of the Federal Reserve and the ESF were $21.9 billion and $19.3 billion respectively. The U.S. monetary authorities regularly invest their foreign currency balances 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 December 3 1, the Federal Reserve and the ESF held, either directly or under repurchase agreement, $9.2 billion and $12.5 billion respectively in foreign government securities.

1. Foreign exchange holdings of U.S. monetary
   authorities at period-end
   Millions of dollars
                                             U.S. Treasury
                           Federal             Exchange
Item                       Reserve        Stabilization Fund
German marks             13,405.2        7,500.6
Japanese yen              8,510.0       11,801.0

Total                   21,915.2           19,301.6

NOTE: Figures may not sum to totals because of rounding.
2. Net profits or losses (-) on U.S. Treasury
   and Federal Reserve foreign exchange operations,
   based on historical cost-of-acquisition exchange rates

Million of dollars
                                   U.S. Treasury
                         Federal        Exchange
Period and item               Reserve        Stabilization
                                             Fund
Valuation profits and losses on
  outstanding assets and liabilities
  as of Sept. 30, 1994             4,973.4        4,356.7
Realized profits and losses,
  Sept. 30, 1994-Dec. 31, 1994            313.7          270.9
Valuation profits and losses on
  outstanding assets and liabilities
  as of Dec. 31, 1994              4,577.6        4,054.1

NOTE: Data are on a value-date basis.

3. Federal Reserve reciprocal currency arrangements

Million of dollars
                         Amount of
Institution                   facility          Drawings
                        Dec. 31, 1994    during period
Austrian National Bank             250         0
National Bank of Belgium            1,000                0
Bank of Canada                        2,000               0
National Bank of Denmark         250                0
Bank of England                       3,000               0
Bank of France                        2,000               0
Deutsche Bundesbank                   6,000               0
Bank of Italy                         3,000               0
Bank of Japan                         5,000               0

Bank of Mexico                        3,000               0
Netherlands Bank                        500               0
Bank of Norway                          250               0
Bank of Sweden                          300               0
Swiss National Bank                   4,000               0

Bank for International Settlements
Dollars against Swiss francs            600               0
Dollars against other authorized
  European currencies                 1,250               0

Total                                32,400               0

(1.) The charts for the report are available on request from Publications Services, Mail Stop 127, Board of Governors of the Federal Reserve System, Washington, DC 20551. (2.) The dollar's movements on a trade-weighted basis in terms of other Group of Ten (G-10) currencies are measured using an index developed by staff at the Board of Governors of the Federal Reserve System. (1.) The charts for the report are available on request from Publications Services, Mail Stop 127, Board of Governors of the Federal Reserve System, Washington, DC 20551. (2.) The dollar's movements on a trade-weighted basis in terms of other Group of Ten (G-10) currencies are measured using an index developed by staff at the Board of Governors of the Federal Reserve System.