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

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

The very sharp swings in exchange rates that occurred around the time of the events in the Soviet Union, after the volatility that had been evident beforehand, had an unnerving effect on many market participants. There were numerous reports that substantial losses arising from the Soviet episode had induced many market participants subsequently to reduce their position-taking activities. The dollar's sharp rise also served as a reminder of the risk of holding short-dollar positions.

The movement of the dollar against the yen, though broadly in the same direction, had been less sharp because the developments in the Soviet Union were perceived to have a less immediate effect on Japan than on Germany. As a result, market participants became persuaded of the merits of using the Japanese yen as a vehicle for taking positions either in favor of or against the German mark because the yen might not entail as much price risk as the dollar.

EARLY SEPTEMBER

In early September, the release of a new round of monthly U.S. data reinforced doubts about the strength of the U.S. recovery and, in a context of renewed calls by U.S. officials for lower U.S. interest rates, revived the negative market sentiment toward the dollar. A steep downward revision in U. S. nonfarm payroll data was reported on September 6, after a downward revision in late August of growth in U. S. second-quarter GNP. The following week, the U.S. Bureau of Labor Statistics released price data that appeared to suggest that the risks of reigniting inflation were low. These data, along with reports of anemic growth in monetary aggregates, further intensified expectations that more aggressive easing by the Federal Reserve lay ahead. On September 13, the Federal Reserve announced a cut of 50 basis points in the discount rate to 5 percent.

At the same time, developments in Germany and Japan served to improve sentiment for the currencies of those countries. Market participants felt that, because the Bundesbank's official interest rate hike in August was at the lower end of the range of expectations, another tightening of German monetary policy could not be ruled out. The contrast in monetary policy orientation in the United States and Germany weighed on the dollar relative to the mark. With respect to the yen, the prospects for interest rates were not so divergent from those in the United States. Indeed, the Japanese authorities were seen as exerting downward pressure on Japanese short-term interest rates to shore up confidence in Japanese financial markets and to respond to evidence suggesting that the Japanese economy was losing steam. At times there was even talk in the market that the authorities in Japan and the United States might act jointly to lower interest rates. Nevertheless, the yen tended to firm relative to the dollar as the outflow of portfolio capital from Japan appeared to be slowing. Many market participants believed that Japanese firms were anxious to improve the yen liquidity of their balance sheets, particularly ahead of the fiscal half-year reporting date at the end of September. It appeared as well that domestic and foreign investors were becoming more confident that the time had come to take advantage of attractive buying opportunities in the Japanese stock market. Under these circumstances, market participants became more willing to sell dollars, and those who needed to buy felt content to postpone their dollar purchases. During the first two weeks of September, the dollar eased more than 3 percent against the mark to just under DM1. 69 as well as 2 percent against the yen to just under [Yen]134.