Treasury and Federal Reserve Foreign Exchange Operations: May-June 1994

May-June 1994 During the May-June period, the dollar declined 4.0 percent against the German mark, 3.0 percent against the Japanese yen, and 2.7 percent on a trade-weighted basis.(1) The dollar opened the period at DM 1.6548 and Y101.75, and closed the period at DM 1.5869 and Y98.50. The Federal Reserve Bank of New York's Foreign Exchange Desk intervened twice during the period on behalf of the U.S. monetary authorities, purchasing $1,250 million on May 4 and $1,560 million on June 24. On both occasions, the Desk intervened as part of a concerted operation to support the dollar. THE UNITED STATES INITIATES A CONCERTED OPERATION In the weeks leading up to the reporting period, the dollar declined against the mark and the yen in increasingly volatile trading. On the last business day of the previous period, the U.S. monetary authorities intervened in the foreign exchange market. On May 4, in early European trading, the dollar reached a new six-month low of DM 1.6330 before recovering to approximately DM 1.6470 after Bundesbank President Tietmeyer stated that too strong an appreciation of the mark against the dollar was not in the interest of the German economy. At about 8:30 a.m., the Desk, joined by eighteen other central banks, entered the market to purchase dollars against the yen and the mark. Shortly after this initial round of intervention, Treasury Secretary Bentsen released the following statement confirming the intervention: I am concerned by recent developments in the exchange markets. This Administration sees no advantage in an undervalued currency. The monetary authorities of the major countries are joining this morning in concerted intervention. These operations reflect our view that recent movements in exchange markets have gone beyond what is justified by economic fundamentals. Following the Secretary's statement, the dollar reached its intraday highs of DM 1.6645 and Y102.40. The Desk continued to purchase dollars against the mark and the yen throughout the morning, concluding the operation at midday. The dollar closed the day at DM 1.6530 and Y101.83. In total, the Desk purchased $1,250 million, of which $750 million was against the mark and $500 million was against the yen. These amounts were equally divided between the Federal Reserve and the U.S. Treasury's Exchange Stabilization Fund (ESF). EXPECTATIONS OF FUTURE INTEREST RATES BEGIN TO CHANGE In the week following the intervention, the dollar gradually firmed against both the mark and the yen. This occurred as market participants came to expect that central banks would follow up on their intervention operations with interest rate changes that would also have the effect of supporting the dollar. In early May, the Bank of Japan was more accommodative in its money market operations, as reflected in a decline in the overnight call money rate to an historical low of 2.03 percent. On May 11, the Bundesbank reduced its discount and Lombard rates by 50 basis points to 4.5 percent and 6.0 percent, respectively. On May 17, the Federal Reserve announced the Board of Governors' decision to raise the discount rate by 50 basis points. At the same time, the Federal Reserve announced a decision by the Federal Open Market Committee (FOMC) to provide a corresponding increase in pressure on bank reserves, resulting in a 50 basis point increase in the federal funds rate. The Federal Reserve Board's statement that the interest rate changes made up to this date in 1994 had remove[d] the degree of monetary accommodation which prevailed throughout 1993 reduced market participants' expectations for further near-term rate increases in the United States. Similarly, the size of the Bundesbank's interest rate cuts lowered expectations for further official reductions in interest rates in Germany. Thus, following these official interest rate changes, expected interest rate differentials, which had widened quite substantially in the dollar's favor in early May, began to narrow rapidly (Chart 2). …