Treasury and Federal Reserve Foreign Exchange Operations

Federal Reserve Bulletin, March, 2000 by Peter R. Fisher, Deborah L. Leonard

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

During the fourth quarter of 1999, the dollar depreciated 3.7 percent against the yen and appreciated 6.2 percent against the euro. On an effective trade-weighted basis, the dollar appreciated 0.8 percent. Market expectations for sustained economic growth in the United States provided underlying support for the dollar and U.S. equity markets. Changes in the dollar's value were also influenced by portfolio flows that contributed to the continued appreciation of the yen and depreciation of the euro. Daily foreign exchange trading volumes fell sharply toward the very end of the quarter, although financial markets demonstrated no discernible signs of dislocation before the century date change. The U.S. monetary authorities did not intervene in the foreign exchange markets during the quarter.

CURRENCY MOVEMENTS DOMINATED BY YEN STRENGTH AND EURO WEAKNESS

Over the course of the fourth quarter, the yen rose steadily to a four-year high of [yen] 101.64 against the dollar and an all-time high of [yen] 102.60 against the euro. The yen's appreciation accompanied continued perceptions of economic improvement in Japan, capital flows into Japanese assets, and uncertainty regarding the prospects for additional stimulus by the Bank of Japan. The movement prompted several publicly confirmed interventions in the foreign exchange markets by the Japanese monetary authorities.

Market participants cited modest signs of improvement in several key Japanese economic data reports and revisions to previous reports as evidence that Japan's economic cycle was turning. Tankan business sentiment indexes in September and December of -22 and -17, respectively, reached the survey's highest levels in two years, although the improvement mainly reflected the results for large manufacturing firms. On November 15, Japan's third-quarter industrial production was reported to have risen 3.9 percent since the previous quarter. On December 6, Japan's third-quarter gross domestic product was reported to have contracted 1.0 percent for the quarter; second-quarter GDP growth, however, was revised upward from 0.1 to 1.0 percent. Market participants also noted three consecutive positive reports of the Economic Planning Agency's monthly leading and coincident diffusion indexes. The Japanese government's November 11 announcement of an [yen] 18 trillion supplementary spending package, including an expected [yen] 6.5 trillion of actual spending, was perceived as demonstrating an ongoing government commitment to employing fiscal stimulus measures.

At the outset of the quarter, attention focused on the prospects for the Bank of Japan to adopt "quantitative easing" measures to invigorate Japan's economy further. The Bank of Japan's announcements of measures aimed at improving the flexibility of its operations and at providing ample liquidity over the turn of the year were perceived as introducing technical changes that did not alter the stance of Japanese monetary policy. Short-term interest rates in Japan rose marginally over the quarter, at times affected by continued evidence of improving economic conditions, strength in the equity markets, and comments from Bank of Japan officials regarding the extraordinary nature of the zero interest rate policy.

Expressing growing confidence in prospects for an upswing in Japan's economy, foreign investors increased their direct and portfolio capital investments in Japan. The Nikkei rose to a two-year high while broader Japanese equity indexes rose even more sharply, buoyed by evidence of corporate restructuring and the global rally in the equity markets. As foreign portfolio inflows continued, the Ministry of Finance reported that foreign direct investment rose to [yen] 1.3 trillion during the first half of 1999, more than twice the amount during the same period in 1998. In the meantime, the yen's persistent appreciation continued to reduce the value of unhedged foreign assets for Japanese investors, further encouraging hedging or liquidation of those positions. Some Japanese investors who were reluctant to maintain large overseas exposures amid year-end uncertainty, reportedly repatriated capital or curtailed investment outflows before the century date change, thus creating additional demand for yen.

In Europe, perceptions that the euro-area economic outlook had improved, views that there were upside risks of inflation, and commentary from European Central Bank (ECB) officials prompted heightened expectations of an interest rate hike by the ECB during the fourth quarter. Expectations solidified after October 27, when year-on-year M3 money supply in the euro area was reported to have grown 6.1 percent in September, outpacing the ECB's target rate of 4.5 percent. On November 4, the ECB raised its two-week refinancing rate 50 basis points, to 3.00 percent. Commenting after the action, ECB President Duisenberg said that the "timely rise [in interest rates] will avoid the need for a bigger rise later." After the move, the yield implied by the March 2000 Euribor futures contract fell to its period low of 3.46 percent, and European sovereign bond yields fell, as market participants noted that the rate rise helped to mitigate expectations of a sustained cycle of monetary tightening in Europe. Yields rebounded in the second half of the quarter, with ten-year sovereign benchmark bond yields rising approximately 50 basis points but remaining below their period highs, amid global declines in bond prices and as economic data pointed to stronger European growth. Germany's 3.2 percent rise in October manufacturing orders, 1.7 percent rise in industrial production the same month, and a better-than-expected November business climate survey by the German IFO Institute all supported the improved expectations for growth. Annualized third-quarter growth in the euro area of 2.3 percent also exceeded consensus forecasts.