Purpose of Foreign Exchange Intervention
The Department of the Treasury and the Federal Reserve, which are the U.S. monetary authorities, occasionally intervene in the foreign exchange (FX) market to counter disorderly market conditions. Since the breakdown of the Bretton Woods system in 1971, the United States has used FX intervention both to slow rapid exchange rate moves and to signal the U.S. monetary authorities' view that the exchange rate did not reflect fundamental economic conditions. U.S. FX intervention became much less frequent in the late 1990s. The United States intervened in the FX market on eight different days in 1995, but only twice from August 1995 through December 2006.
Scope of the FX Market
The foreign exchange market is a network of financial institutions and brokers in which individuals, businesses, banks and governments buy and sell the currencies of different countries. They do so in order to finance international trade, invest or do business abroad, or speculate on currency price changes. On average, the equivalent of about $1.9 trillion in different currencies is traded daily in the FX market around the world.
There are two primary types of transactions in the FX market. An agreement to buy or sell currency at the current exchange rate is known as a spot transaction. By convention, spot transactions in most currency pairs are settled two days later, with the main exception of the U.S. dollar - Canadian dollar currency pair. In a forward transaction, traders agree to buy and sell currencies for settlement at least three days later, at predetermined exchange rates. This second type of transaction often is used by businesses to reduce their exchange rate risk.
The Effects of Exchange Rate Changes
An exchange rate is the price of one foreign currency in terms of another currency. Foreign exchange rates are of particular concern to governments because changes in FX rates affect the value of products and financial instruments. As a result, unexpected or large changes can affect the health of nations' markets and financial systems. Exchange rate changes also impact a nation’s international investment flows, as well as export and import prices. These factors, in turn, can influence inflation and economic growth.
For example, suppose the price of the Japanese yen moves from 120 yen per dollar to 110 yen per dollar over the course of a few weeks. In market parlance, the yen is "strengthening" or “appreciating” against the dollar, which means it is becoming more expensive in dollar terms. If the new exchange rate persists, it will lead to several related effects. First, Japanese exports to the United States will become more expensive. Over time, this might cause export volumes to the United States to decline, which, in turn, might lead to job losses for exporters in Japan. Also, the higher U.S. import prices might be an inflationary influence in the United States. Finally, U.S. exports to Japan will become less expensive, which might lead to an increase in U.S. exports and a boost to U.S. employment.
Expected interest rate differentials between countries are one of the main factors that influence exchange rates. Money tends to flow into investments in countries with relatively high real (that is, inflation-adjusted) interest rates, increasing the demand for the currencies of these countries and, thereby, their value in the FX market.
The Role of the Federal Reserve
Congress has assigned the U.S. Treasury primary responsibility for international financial policy. In practice, though, the Treasury's FX decisions typically are made in consultation with the Federal Reserve System. If the monetary authorities elect to intervene in the FX market, the intervention is conducted by the Federal Reserve Bank of New York. When a decision is made to support the dollars' price against another currency, the foreign exchange trading desk of the New York Fed buys dollars and sells the foreign currency; conversely, to reduce the value of the dollar, it sells dollars and buys the foreign currency. While the Fed's trading staff may operate in the FX market at any time and in any market in the world, the focus of activity usually is the U.S. market.
Because the Fed's purchases or sales of dollars are small compared with the total volume of dollar trading, they do not shift the balance of supply and demand immediately. Instead, intervention affects the present and future behavior of investors. In this regard, U.S. foreign exchange intervention is used as a device to signal a desired exchange rate movement.
The Intervention Process
The foreign currencies that are used to intervene usually come equally from Federal Reserve holdings and the Exchange Stabilization Fund of the Treasury. These holdings currently consist of euros and Japanese yen. Interventions may be coordinated with other central banks, especially with the central bank of the country whose currency is being used.
In recent years, the Federal Reserve and the Treasury have made their interventions more transparent. Thus, the New York Fed often deals directly with many large interbank dealers simultaneously to buy and sell currencies in the spot exchange rate market. The Fed historically has not engaged in forward or other derivative transactions. The Treasury Secretary typically confirms U.S. intervention while the Fed is conducting the operation or shortly thereafter. Often, statements that reflect the official U.S. stance on its exchange rate policy accompany the Treasury's confirmation of intervention activity.
The Federal Reserve routinely "sterilizes" intervention in the FX market, which prevents the intervention from changing the amount of bank reserves from levels consistent with established monetary policy goals. For instance, if the New York Fed sells dollars to buy a foreign currency, the sale adds reserves to the banking system. In order to sterilize the transaction, the Fed, in its domestic open market transactions, may remove reserves through the sale of government securities.
The Federal Reserve Bank of New York announces full details of the U.S. monetary authorities' foreign exchange activities approximately 30 days after the end of every calendar quarter in a report issued to Congress and simultaneously made public entitled "Treasury and Federal Reserve Foreign Exchange Operations".
Not all New York Fed trading desk activities in the market are directed by the Treasury Department or Federal Reserve. On occasion, the New York Fed may act as agent on behalf of other central banks and international organizations wishing to participate in the FX market in the United States, with no money of U.S. monetary authorities involved. The foreign central bank uses the New York Fed as its agent, beyond its time zone and its regular FX counterparties. These purchases and sales are not considered to be U.S. FX intervention, nor are they intended to reflect any policy initiative of the U.S. monetary authorities. When the Federal Reserve buys and sells currencies on behalf of foreign central banks, the aggregate level of bank reserves does not change, and sterilization is not needed.