U.S. Foreign Exchange Intervention
Purpose of Foreign Exchange Intervention
Scope of the FX Market
There are two primary types of transactions in the FX market. An agreement to buy or sell currency at the current exchange rate is known as a spot transaction. By convention, spot transactions in most currency pairs are settled two days later, with the main exception of the U.S. dollar - Canadian dollar currency pair. In a forward transaction, traders agree to buy and sell currencies for settlement at least three days later, at predetermined exchange rates. This second type of transaction often is used by businesses to reduce their exchange rate risk.
The Effects of Exchange Rate Changes
For example, suppose the price of the Japanese yen moves from 120 yen per dollar to 110 yen per dollar over the course of a few weeks. In market parlance, the yen is "strengthening" or “appreciating” against the dollar, which means it is becoming more expensive in dollar terms. If the new exchange rate persists, it will lead to several related effects. First, Japanese exports to the United States will become more expensive. Over time, this might cause export volumes to the United States to decline, which, in turn, might lead to job losses for exporters in Japan. Also, the higher U.S. import prices might be an inflationary influence in the United States. Finally, U.S. exports to Japan will become less expensive, which might lead to an increase in U.S. exports and a boost to U.S. employment.
Expected interest rate differentials between countries are one of the main factors that influence exchange rates. Money tends to flow into investments in countries with relatively high real (that is, inflation-adjusted) interest rates, increasing the demand for the currencies of these countries and, thereby, their value in the FX market.
The Role of the Federal Reserve
Because the Fed's purchases or sales of dollars are small compared with the total volume of dollar trading, they do not shift the balance of supply and demand immediately. Instead, intervention affects the present and future behavior of investors. In this regard, U.S. foreign exchange intervention is used as a device to signal a desired exchange rate movement.
The Intervention Process
In recent years, the Federal Reserve and the Treasury have made their interventions more transparent. Thus, the New York Fed often deals directly with many large interbank dealers simultaneously to buy and sell currencies in the spot exchange rate market. The Fed historically has not engaged in forward or other derivative transactions. The Treasury Secretary typically confirms U.S. intervention while the Fed is conducting the operation or shortly thereafter. Often, statements that reflect the official U.S. stance on its exchange rate policy accompany the Treasury's confirmation of intervention activity.
The Federal Reserve routinely "sterilizes" intervention in the FX market, which prevents the intervention from changing the amount of bank reserves from levels consistent with established monetary policy goals. For instance, if the New York Fed sells dollars to buy a foreign currency, the sale adds reserves to the banking system. In order to sterilize the transaction, the Fed, in its domestic open market transactions, may remove reserves through the sale of government securities.
The Federal Reserve Bank of New York announces full details of the U.S. monetary authorities' foreign exchange activities approximately 30 days after the end of every calendar quarter in a report issued to Congress and simultaneously made public entitled "Treasury and Federal Reserve Foreign Exchange Operations".
Not all New York Fed trading desk activities in the market are directed by the Treasury Department or Federal Reserve. On occasion, the New York Fed may act as agent on behalf of other central banks and international organizations wishing to participate in the FX market in the United States, with no money of U.S. monetary authorities involved. The foreign central bank uses the New York Fed as its agent, beyond its time zone and its regular FX counterparties. These purchases and sales are not considered to be U.S. FX intervention, nor are they intended to reflect any policy initiative of the U.S. monetary authorities. When the Federal Reserve buys and sells currencies on behalf of foreign central banks, the aggregate level of bank reserves does not change, and sterilization is not needed.