Treasury and Federal Reserve foreign exchange operations - August - October, 1991

Federal Reserve Bulletin, Jan, 1992 by Margaret L. Greene, Roger M. Scher

This quarterly report, covering the period August through October 1991, provides information on Treasury and System foreign exchange operations. It was presented by Margaret L. Greene, Senior Vice President of Foreign Exchange at the Federal Reserve Bank of New York. Roger M. Scher was primarily responsible for preparation of the report.(1)

The dollar, having already come down from its post-gulf-war highs before the beginning of August, moved irregularly and moderately lower during the August-October period under review. This development occurred as the recovery of the U. S. economy appeared both slower to emerge and less vigorous than had been anticipated in earlier months. The dollar eased during the three-month period more than 4 percent against the mark, close to 5 percent against the yen, and about 33A percent on a trade-weighted basis? The U.S. monetary authorities did not intervene in the foreign exchange markets during the period.

AUGUST

As the period opened, the dollar was generally trading with a negative bias, weighed down by widening interest rate differentials adverse to the dollar. Previously, market participants had expected that the United States would emerge quickly out of recession at a time when some other economies might be slowing and that the large interest rate differentials providing a disincentive to investment in dollar-denominated assets would thereby be eliminated. But U. S. data released around the beginning of August caused a reappraisal of this view, raising questions about the vigor of the U.S. economy and renewing talk of further declines in U.S. interest rates. At the same time, the Japanese authorities were trying to dampen expectations that a reduction of the Bank of Japan's official discount rate in early July would quickly be followed by another such move. In Germany, new data revealing rising inflation encouraged expectations that the Bundesbank would raise official interest rates to contain inflationary pressures before the start of important labor negotiations for the coming year.

Against this background, the dollar showed some vulnerability to selling pressure in early August, particularly against the mark. Publication of a weak July nonfarm payroll employment report, after a succession of other worse-than-expected U.S. statistics, prompted a 2 percent drop in the dollar from its high of DM1.7675 on August 2. Evidence that the Federal Reserve had eased the federal funds rate 25 basis points on August 6 triggered a new round of selling of the dollar against the mark that took the exchange rate briefly below DM1.70 on August 8. But around mid-August, when the Bundesbank announced that it was raising its official Lombard rate less than the market had expected, the dollar almost completely reversed its decline of the previous weeks. Against the yen, the dollar followed a similar pattern, easing from a high of M138 on August 2 to almost 4135 about a week later before retracing some of its decline. But these movements were somewhat more subdued because revelations surrounding scandals in Japan's financial markets were weighing on the Japanese currency.

News early on Monday, August 19, that Soviet President Gorbachev had been removed from office sparked a sudden scramble for dollars. The prospect that the Soviet leader would be replaced by a reactionary government seeking to roll back the reforms that permitted liberalization in Eastern Europe and the unification of Germany inflamed the markets' deepest anxieties about the outlook for Europe, in general, and Germany, in particular. Market participants, seeking safe havens for currency, moved funds out of marks and into other currencies, including the U. S. and Canadian dollars and the Swiss franc-currencies thought to be geographically insulated from whatever potential political disruption and social unrest might ensue. In a matter of hours, the dollar rose 7 pfennigs, or about 4 percent, to touch DM 1. 8350, amid fears that the coup attempt would lead immediately to widespread violence. By the time New York trading began that day, the dollar had come well off its highs after reports circulated that several central banks had been intervening and as the likelihood of violence in the Soviet Union appeared to diminish. In these circumstances, no intervention was undertaken by the U.S. authorities. By Wednesday, August 21, reports circulated that the putsch had failed and that Gorbachev would return to office. Market participants were impressed by the strength of public support for a more democratic government in the Soviet Union and at the same time surmised that the threat to continued liberalization might induce Western nations to offer substantial assistance to Eastern Europe. Thus, the outlook for Germany and the mark appeared somewhat improved on balance. In response, the dollar quickly fell back below its precoup levels. By the end of August, the dollar was trading near levels that prevailed at the beginning of the month, closing at DM1.7465 and 136.80.