Treasury and Federal Reserve Foreign Exchange Operations

Federal Reserve Bulletin, Dec, 1999 by Peter R. Fisher, Deborah L. Leonard

This quarterly report describes US. Treasury and System foreign exchange operations for the period from July through September 1999. It was presented by Peter R. Fisher, Executive Vice President, Federal Reserve Bank of New York, and Manager, System Open Market Account. Deborah L. Leonard was primarily responsible for preparation of the report.

During the third quarter of 1999, the dollar depreciated 12.1 percent against the yen and 3.2 percent against the euro. Dollar movements mainly reflected prospects for more balanced global growth, particularly among the major economies. The yen's substantial appreciation during the quarter against both the dollar and the euro was accompanied by sizable portfolio flows as international investors reassessed views of expected risk-adjusted returns in global capital markets. The U.S. monetary authorities did not intervene in the foreign exchange markets during the quarter.

IMPROVEMENT IN THE OUTLOOK FOR GLOBAL ECONOMIC GROWTH

The U.S. economy continued to show buoyant activity in the third quarter, although its pace of growth appeared to slow. Expectations for aggressive monetary policy tightening in the united States waned in the initial weeks of the quarter after the Federal Open Market Committee (FOMC) raised the federal funds target rate from 4.75 to 5.00 percent and adopted a neutral policy stance on June 30. Many market participants posited that benign price data and forecasts of slower growth made further near-term policy changes less likely. Nevertheless,' yields on U.S. Treasury securities rose to fifteen-month highs after Chairman Greenspan warned in his July 22 Humphrey-Hawkins testimony that the FOMC would act "promptly and forcefully" should inflationary pressures emerge. Rising commodity prices, particularly for oil, also raised some concerns about the outlook for inflation. The subsequent release of lower-than-expected second-quarter GDP growth of 2.3 percent on July 29 and subdued consumer and producer price reports shortly after that date supported the view that further tightening might not be imminent, even though labor markets remained taut and the manufacturing sector remained strong. The FOMC raised the federal funds target rate 25 basis points, to 5.25 percent on August 24, with an accompanying statement that the two recent rate increases should "markedly diminish the risk of rising inflation going forward." A weaker-than-expected report on nonfarm payrolls on September 3 and moderate consumer price data on September 15 bolstered this sentiment.

Signs of ongoing economic stabilization in Japan were reflected in data releases throughout the third quarter. Strong industrial production figures released on July 29 showing a 3.0 percent rise in output for June were followed on August 13 by a slight upward revision to the already surprisingly strong reading for first-quarter GDP growth, from 1.9 percent to 2.0 percent over the fourth quarter of 1998. Second-quarter GDP data released on September 9, also surprisingly strong, showed growth of 0.2 percent compared with market expectations for a contraction of 0.3 percent. Several market participants cited gains in Japanese equities as a reflection of growing confidence in Japan's recovery, as the small-capitalization JASDAQ index soared 26 percent during the quarter; however, the Nikkei index traded in a narrower range amid the uncertain effect of a stronger yen on shares of large-capitalization exporters.

Improving economic indicators across Europe provided mounting evidence of a cyclical recovery in the euro area. Throughout the quarter, many private and multilateral institutions revised upward their forecasts of economic growth. Data releases early in the quarter were inconclusive, but a marked improvement in surveys of German and French business sentiment and manufacturing orders later in the period led to growing expectations for an upswing in industrial activity across Europe. On July 15, European Central Bank (ECB) President Duisenberg suggested that a "[tightening] bias was gradually creeping" into the ECB's policy considerations. Toward the end of the quarter, expectations for a near-term tightening solidified as producer prices rose across Europe, surveys of purchasing managers indicated higher prices paid for inputs, and senior ECB officials highlighted the risks of inflation in their public comments.

EXPECTATIONS FOR MONETARY POLICY ACTIONS SHIFT

Fundamental economic developments and comments from public officials in the United States, Japan, and Europe contributed to changing expectations for monetary policy actions throughout the quarter. In the United States, the FOMC's choice of a symmetric policy outlook after monetary policy tightenings on June 30 and again on August 24 encouraged market participants to carefully evaluate new information for potential signs of near-term policy direction. Early in the quarter, the implied yield on the December federal funds futures contract fell 16 basis points, as market participants responded to the neutral bias, and then rose 28 basis points after Chairman Greenspan's Humphrey-Hawkins testimony. However, the implied yield then fell 14 basis points from its period high of 5.49 percent, to end the quarter relatively unchanged. In Europe, forecasts of stronger growth, rising inflation, and comments from ECB officials contributed to the view that the balance of risks implied a tightening of European monetary policy sooner rather than later.