|
The Richmond Fed
reports that The Fed Debate in the 1960s over
Sterilized Foreign Exchange Intervention.
(emphasis mine) [my
comment]
Sterilized
Foreign Exchange Intervention: The Fed Debate in the 1960s
Robert L. Hetzel
In early 1962, the Federal Reserve System (the Fed) began to buy and sell
foreign currency. The decision to intervene in foreign exchange markets was
controversial and generated considerable internal debate. The debate
involved the fundamental issue of the Fed’s independence from the
Treasury. The Treasury has primary responsibility for official
foreign exchange operations in the United States. Hence, participation with
the Treasury in foreign exchange operations could jeopardize Fed
independence. Moreover, the Federal Reserve Act safeguards this independence
by requiring that acquisition of Treasury debt by the Fed be done in the open
market, that is, at the Fed’s discretion rather than at the behest of
the Treasury. The practice of acquiring foreign exchange directly from
the Treasury in support of the Treasury’s operations could erode that
safeguard.
Former Secretary of the Treasury George Shultz (Shultz and Dam 1978, p. 9)
stated flatly, “. . . the Fed takes direction from the President,
through the Treasury Department, on international monetary affairs.”
Stephen Axilrod (Burk 1992, p. 41), formerly Staff Director for Monetary and
Financial Policy at the Board of Governors, noted
. . . there is a deep distinction in the U.S. (unlike the U.K.) between
international and domestic monetary policy: the Fed is totally and utterly
independent when making a domestic monetary policy decision; not only is
there no clearance with the Treasury—to attempt it would cause a
constitutional crisis. The international arena is more complicated: here
the Fed’s independence is unknown and has not been fully tested, but in
practice it is limited. The Treasury controls international finance.
The debate also dealt with whether the Federal Reserve Act authorized the Fed
to transact in foreign exchange. This article reviews the debate and briefly
addresses subsequent developments. As background, the article begins with a
brief historical overview of the Bretton Woods system and the Treasury’s
Exchange Stabilization Fund.
1. BRETTON WOODS
In 1962, the United States was part of the Bretton Woods system. That
international monetary arrangement attempted to recreate key parts of the
gold standard, which had collapsed in the Depression. Member countries other
than the United States pegged their currencies to the dollar. The United
States agreed to maintain convertibility of the dollar to gold at the rate of
$35 per ounce. As required by the Federal Reserve Act, before 1968 Federal
Reserve notes were collateralized in part by gold.
If the United States ran a balance of payments deficit and lost enough gold,
the Fed would have to contract the money stock. According to the classical
view of the gold standard, a reduction in the money stock would reduce the
price level and make U.S. goods cheaper to foreigners, who would increase
their purchases of U.S. goods. The resulting decline in the external deficit
would end the gold outflow. Under the Bretton Woods system, as under the
classical gold standard, the price level was supposed to adjust to achieve
balance in the country’s external accounts.
By early 1959, the currencies of the countries in the European Economic
Community had become fully convertible into the dollar (for current account
transactions). (This review draws on Coombs [1976], Roosa [1967], and Solomon
[1982].) These countries, however, established exchange rates that overvalued
the dollar (made U.S. goods too expensive). Consequently, the United States
ran a significant, persistent balance of payments deficit. Foreign central
banks financed part of the U.S. payments deficit by accumulating dollars, and
foreign investors financed part of it by willingly holding dollar assets. However,
between 1959 and 1961, the U.S. Treasury had to finance the remainder of the
deficit through sales of gold to foreign central banks. Countries relying
on the United States for defense (Germany, Japan, and Italy) refrained from
gold purchases. Other countries (like Belgium, the Netherlands, and Great
Britain) were fearful of being caught with a devalued dollar in their
portfolios and enforced the Bretton Woods discipline by asking the U.S.
Treasury for gold. By the end of 1960, U.S. gold losses had become front-page
news in papers like The New York Times.
In the early 1960s, monetary policymakers walked a tightrope requiring them
to balance internal and external objectives. The 1960 recession pushed U.S.
short-term interest rates below those in Europe. That difference in rates
spurred a capital outflow, widened the payments deficit, and aggravated the
loss of the Treasury’s gold reserve. While in the middle of the 1960
presidential campaign, the country faced both a domestic recession and a
balance of payments deficit, each requiring conflicting policy responses.
In 1954, Britain had reopened the London gold market. By 1960, it had
acquired a status comparable to the long-term bond market of today. Quotations
for the price of gold were a “barometer of confidence in both the
gold-dollar parity and the Bretton Woods system generally”
(Coombs 1976, p. 14). Through most of the 1950s, sales of gold by South
Africa and the Soviet Union had kept the free market price at $35 per ounce.
In 1960, however, the concern arose in Europe that a Democrat might win the
U.S. presidency and pursue expansionary domestic policies.
On October 20, 1960, the London gold price suddenly shot up from close to $35
an ounce to $40 an ounce. That created an arbitrage opportunity for foreign
central banks willing to sell gold in London and replace it by asking the
U.S. Treasury for gold. The Treasury decided to maintain the $35 price of
gold in the London market with gold sales. On October 31, 1960, candidate
John Kennedy promised that if elected he would maintain convertibility at the
$35 parity. Later as the President, in his February 6, 1961, message on the
balance of payments, he promised that the $35 price of gold was
“immutable.” The immediate crisis passed, but the drain of gold
continued as Kennedy took office in January 1961, and the position of the
dollar remained precarious.
The Federal Open Market Committee (FOMC) Minutes in 1961 reveal a
persistent concern over the U.S. balance of payments deficit, offset by
a concern for unemployment. For example, the Minutes (Board
of Governors 1961, pp. 935–36) paraphrase one governor:
Mr. Mitchell noted that the Chairman of the Council of Economic Advisers
had said recently that if unemployment did not decline, it would be up to the
Administration to create jobs. However, he (Mr. Mitchell) felt that it would
be better if the private economy could be persuaded to create jobs. Monetary
policy should do whatever it could to make this possible. . . . Foreigners
wanted to know how this country was going to get its payments position into
balance, but he did not feel that anyone in this country knew the answer to
this question. As he saw it, the Federal Reserve could do just one thing
about the balance-of-payments problem. It could encourage foreigners to leave
their money in this country by making interest rates competitive with those
in key European countries. In his opinion, however, carrying this policy much
farther than it had been carried in recent months would be too high a price
to pay at the moment, considering the importance of a somewhat lower level of
interest rates to stimulate the domestic economy. [The
unwillingness to accept higher unemployment is what destroyed the
dollar’s value]
In 1961, the FOMC raised interest rates twice out of a concern for the
external deficit. At the October 24, 1961, meeting, the FOMC raised bill
rates from about 21/4 to 21/2 percent. New York Fed President Hayes, who as
vice chairman presided over the meeting in the absence of Chairman Martin,
commented (Board of Governors 1961, pp. 897–98)
That at least a goodly number of those around the table had expressed
some concern about the international problem and had recognized that there
was perhaps something the System could do to help, in a minor way, to show
that it was aware of the problem, without doing danger to the domestic
economy.
Governor Mills expressed the general sentiment for an increase in rates at
the December 19 meeting (Board of Governors 1961, p. 1079):
Patently, time is of the essence in reorienting the existing monetary and
credit policy in the direction of moderate restraint. . . . What I consider
as having been an unpardonable delay in pursuing that objective has permitted
distrust in the exchange value of the U.S. dollar to grow and will
consequently vitiate counteroffensive interest rate efforts to stem the loss
of gold from this country. Reliance on collective central bank and
International Monetary Fund actions to protect the U.S. dollar should have
been reserved for secondary emergency application and not suggested for
continuing use, in that public notice of resort to these media will be
regarded by cynical investors as acts of desperation and not as curatives to
temporary problems of international currency imbalances.
Initially, Chairman Martin urged postponement of a rise in rates, but he then
relented (Board of Governors 1961, pp. 1089–90 and 1136):
He questioned whether the situation had really come to the point where a
significant change of policy was required. . . . He would hope
that the System would not get itself in the position, following the increase
in the maximum permissible interest rates on time and savings deposits, of
being charged with causing the commercial bank prime rate to be increased at
this particular juncture. [The Board of Governors had decided to raise the Reg
Q ceiling on deposits held for one year or more from 3 to 4 percent,
effective January 1, 1962.]
Following additional discussion, Chairman Martin restated his conception of
the consensus of the meeting. As he saw it, the consensus was along the lines
of concentrating on a bill rate in the upper part of the range of 21/2 - 23/4
percent.
The external deficit kept the FOMC from lowering market rates in July 1962 in
response to weakness in economic activity. The bill rate, however, only began
to rise significantly in June 1963 when it first reached 3 percent.
With monetary policy basically immobilized because of weakness in the
domestic economy, the United States was left with only ad hoc measures to
deal with the balance of payments deficit. In 1961, it reduced the duty-free
allowance on goods purchased abroad by American tourists from $500 to $100. The
United States moved to limit the demand for its gold stocks by making it
illegal for Americans to buy gold abroad. In 1962, it set up the London Gold
Pool among central banks to curb central bank free market purchases of gold.
The U.S. government asked Germany to pay more of the expense of maintaining
U.S. troops in Germany.
The Treasury issued bonds denominated in foreign currencies, named Roosa
bonds after Treasury Under Secretary Robert Roosa, to obtain foreign currency
to purchase dollars. The Treasury and the Fed also began Operation
Twist, whereby the Fed began to hold longer-term securities, and the
Treasury began to issue mainly shorter-term securities [They began a new
“Operation Twist” in the 1990s]. The resulting decrease in the
supply of longer-term securities relative to shorter-term securities was
supposed to lower longer-term interest rates relative to shorter-term
interest rates. The idea was to encourage both domestic investment and
short-term capital inflows. Although the balance of payments exercised
some influence on monetary policy, the FOMC was unwilling to
subordinate domestic to external considerations.
2. THE EXCHANGE STABILIZATION FUND
In 1961, the Exchange Stabilization Fund (ESF) of the U.S. Treasury began to
intervene in the foreign exchange markets. Its ability to intervene, however,
was limited by its resources. In 1934, Congress had created the ESF with
the Gold Reserve Act. Congress capitalized it with $2 billion of the profits
created by that Act’s revaluation of gold from $20.67 to $35.00 per
ounce. It put the ESF under the control of the Treasury and authorized it to
intervene in the foreign exchange markets to stabilize the value of the
dollar. In 1945, the Bretton Woods Agreements Act transferred $1.8 billion of
the ESF’s capital to the International Monetary Fund (IMF). The ESF,
therefore, was left with $200 million in its capital account and no alternative
funding sources apart from money appropriated by Congress (see Todd [1991,
1992]). However, over the years, the ESF had earned profits through its
purchases and sales of gold. It invested these profits in domestic and
foreign securities. With the income from those securities, by June 30, 1961,
it had accumulated about $336 million in assets. (Figures on the balance
sheet of the ESF come from U.S. Treasury Annual Reports.)
By 1962 the ESF had committed much of its resources through provision of
foreign aid, especially to Latin American countries. In 1960, it had
acquired Argentine pesos. In May 1961, the ESF agreed to exchange up to $70
million dollars for Brazilian cruzeiros (U.S. Treasury 1961, p. 369). On
January 1, 1962, the ESF entered into an exchange agreement with Mexico for
$75 million, and in the middle of 1962 it entered into a swap agreement with
the Philippines (U.S. Treasury 1963, p. 57).1
1 At times, the ESF obtained the foreign exchange needed to purchase dollars
in the foreign exchange market by borrowing from foreign central banks
through an arrangement called a “swap.” At other times, when the
ESF needed dollars, in an arrangement called “warehousing,” it
would organize a trade with the foreign exchange in the Fed’s inventory
in return for dollars. The appendix explains the details of these two kinds
of transactions.
Because so much of its resources were tied up, the ESF intervened
mainly in the forward markets [important point]. In that way, it
would only need foreign exchange if it had to close out a position at a
loss. “Reference was made to the extent of operations of the
ESF in the forward market, as opposed to spot transactions, and Mr. Coombs
[manager of the New York Fed’s foreign exchange desk] said the basic
reason was that the ESF was short of money” (Board of Governors 1962,
p. 169). The dollar often traded at a large discount in the forward market.
The Treasury entered into commitments to furnish foreign currencies in the
future in order to reduce this discount. In doing so, it hoped to encourage
individuals to hold dollar-denominated assets by reassuring them that the
dollar would not depreciate in value.
In March 1961, the British pound weakened while the German mark and Dutch
guilder strengthened. Germany and the Netherlands revalued their currencies
by 5 percent.2 Because many in the foreign exchange markets believed that a
10 percent revaluation would be required to eliminate the German balance of
payments surplus, capital continued to flow into Germany. In forward markets,
the mark commanded a 4 percent premium.
German exporters . . . hedged by borrowing dollars . . . and converting these
dollars into deutsche marks immediately, counting on the future dollar
receipts to repay the dollar loans on maturity. Activities of this nature
significantly increased the volume of dollars being offered on the exchange
market, compelling the German Bundesbank to acquire dollars in huge amounts.
. . . U.S. authorities were confronted with the possibility that the Germans
would have to purchase gold in order to prevent a further drop in their
already low gold/dollar ratio (U.S. Treasury 1962a, p. 3; Foreign 1962).
By the end of June, the ESF had entered into forward contracts agreeing to
deliver more than $250 million deutsche marks for dollars in the future.
Fortunately, the Treasury was able to unwind these positions without putting
pressure on the dollar in the summer because the Berlin Wall crisis produced
a weakening of the deutsche mark.
The Berlin crisis, however, produced capital flight to Switzerland, and
the Swiss franc commanded a premium of 11/2 percent in the forward market. Starting
in July, the ESF began to sell Swiss francs forward to Swiss commercial
banks, which then became willing to hold the dollars instead of turning them
over to the Swiss National Bank. If the Swiss National Bank had been forced
to purchase the dollars, it would have been under pressure to use them to buy
gold from the Treasury. Toward the end of 1961, the Italian lira became
the strongest European currency, and the Italian central bank came under
pressure to exchange the dollars it was accumulating for gold. In an attempt
to encourage Italian commercial banks to hold dollars rather than turn them
over to the central bank, the ESF entered into $200 million in forward
contracts. The forward commitments of the ESF in lira and Swiss francs
amounted to $346.6 million in early 1962.
Forward commitments, however, carried the risk of loss if the dollar did
not appreciate. Given the risk exposure due to the size of its forward
commitments, the Treasury felt that the ESF had insufficient cash on
hand. To provide it with additional cash, the Treasury wanted
the Fed to buy the ESF’s foreign currencies such as the deutsche mark
[important point]. The ESF could then acquire the lira and Swiss francs it
needed to meet its forward commitments without having to incur the ire of
other central banks by dumping their currencies on the market in return for
lira and Swiss francs.
A Treasury memo (Foreign 1962; U.S. Treasury 1962b, p. 2) noted
Total resources of the Fund at the present time amount to about $340
million. Against these resources there are outstanding $222 million in
Exchange Stabilization agreements with Latin American countries, and some
additional agreements may be made from time to time. The free resources of
the Stabilization Fund are consequently quite small. . . . Spot holdings of
foreign exchange now amount to about $100 million . . . . These spot holdings
must in general be thought of as providing backing for outstanding forward
exchange contracts (currently about $340 million equivalent).
The entrance of the Federal Reserve System into foreign exchange operations
will therefore provide particularly needed resources.
As Charles Coombs (1976, p. 71) put it later, “. . . the
money-creating authority, the Federal [Reserve] could rise to almost any
financial emergency, whereas the Treasury was confined, in the absence of new
Congressional appropriations, to the existing $330 million resources of its
Stabilization Fund.”
3. LOOKING TO THE FED
On June 27, 1961, Ralph Young, Adviser to the Board of Governors, distributed
to FOMC members a memo proposing that the Fed become involved in the
coordinated foreign exchange intervention started by other central banks in
response to the March sterling crisis. When the pound sterling had
weakened, the Bank of England used its dollar reserves to buy pounds. The
resulting outflow of dollars ended up at other European central banks.
Although those banks recycled the dollars by lending them to the Bank of
England, the U.S. Treasury was concerned that the banks might use the dollars
to buy gold from the United States. To safeguard against such an event, Young
recommended that the Fed open swap lines with other central banks as a way of
acquiring foreign exchange to buy dollars if necessary.3 He also recommended
that the Fed stand ready to replenish the ESF’s dollar holdings by
purchasing its foreign exchange through a procedure later termed
“warehousing.”4
3 As explained in Appendix A, in a swap the Fed or the ESF places dollar
deposits with a foreign central bank, which in return places deposits in its
currency with the Fed. Appendix A explains how the foreign exchange acquired
through swaps was used to insure foreign central banks against loss of value
of their dollar holdings in the event of a devaluation of the dollar. In this
way, the United States persuaded foreign central banks not to purchase gold.
4 As explained in Appendix A, with warehousing the Fed credits the
Treasury’s deposits with the Fed in exchange for foreign exchange held
by the ESF.
Young’s (1961, p. 8; Foreign 1961) memo stated
The assets of the Stabilization Fund cannot, without Congressional action,
be increased beyond the present amount of about $360 million. Part of this
amount is immobilized under present exchange agreements with Latin American
countries. The rest is not sufficient to cope with the swings in holdings of
foreign exchange . . . in periods of disturbed exchange market conditions.
Chairman Martin first raised the issue of foreign exchange intervention at an
FOMC meeting on September 12, 1961. He let William Treiber, first vice
president of the New York Fed, take the lead. Treiber (Board of Governors
1961, pp. 798–99) noted the weakness in the dollar and the ESF’s
lack of resources:
[The ESF’s] present size is about $1/3 billion, of which a large amount
is already tied up by stabilization agreements with certain Latin American
countries. The scope of acquisition of hard currencies by the Fund is
probably not much over $100 million. While the Treasury may eventually ask
the Congress to authorize an increase in the resources of the Fund, I
understand that in any case the Treasury would welcome Federal Reserve
acquisition of foreign exchange as a helpful supplement. . . . Abrupt
declines of the dollar to the floor of the foreign exchanges have excited
speculation as to possible changes in currency parities . . . an adequate
supply of the major foreign currencies . . . [would] restrain a snowballing
of speculative anticipations.
Young noted that the Treasury would like the Fed to become involved
in foreign exchange intervention so that it could use the ESF’s
funds for other purposes:
Mr. Young pointed out . . . that the Treasury has other jobs in connection
with the Stabilization Fund. That was one of the reasons why the funds
available for the particular kinds of operations under discussion were so
limited. He gathered that the Treasury might be happy if it were left free to
use the Stabilization Fund for the other things with which it had to deal (p.
815).
Carl Allen (Board of Governors 1961), president of the Chicago Fed, began
a discussion of the legality of Fed intervention in foreign exchange markets
and Karl Bopp, president of the Philadelphia Fed, raised the
issue of whether the Fed could retain its independence while working
with the Treasury: [presidents are not political appointees, so they
tend to care more about things like inflation and the rule of the law]
Just because a thing was legal, that did not mean that he [Allen] would
always want to do it. On the legality of the proposed operations, however,
he did have a question . . . whether it seemed clear that it would be legal
for the System to undertake such operations (p. 801).
. . . The Chairman then turned to Mr. Hackley [Board Counsel], who commented
that legal questions had, of course, been raised in the past. Nearly 30
years ago, as indicated in Mr. Young’s memorandum, the Board
took a position, which it did not publish, that would seem to preclude
the implementation of the program such as suggested. However, for reasons
that did not need to be gone into today, he felt that the Board could well
reinterpret the law in a somewhat different manner, and in his view such a
step would be desirable. . . . Chairman Martin then stated that he had
mentioned this subject informally—not formally—to the Chairmen of
the Senate and House Banking and Currency Committees. . . . It would
not be fair to say that the Committee Chairmen had given any clearance of any
kind (p. 802).
The Chairman went on to comment. . . . There was a very real point . . . that
the primary direction must come from the Treasury and that anything
done by the Federal Reserve must be coordinated with the Treasury. . . . Everyone
. . . ought to keep in mind what the framework was. Also, before entering
into any such operations, the System ought to do as the memorandum from Mr.
Young suggested; namely, take the matter up formally with the Chairmen of the
Banking and Currency Committees (p. 803).
Mr. Bopp said that as nearly as he could recall . . . one reason for its
[ESF’s] creation was dissatisfaction with the idea of the Federal
Reserve handling foreign exchange operations. . . . Through the
Stabilization Fund . . . the Treasury was to have the authority in case of
any conflict. . . . In the longer run, he noted, a possible conflict could
develop between Treasury policy and Federal Reserve policy in this area.
This was a thing to keep in mind . . . the sense in which the Treasury
could direct Federal Reserve operations in this field even though Federal
Reserve funds were used (p. 804). . . . Mr. Bopp then commented that
he was sympathetic to the approach suggested in Mr. Young’s memorandum
(p. 805).
Governor Robertson [Board Vice Chairman] was especially skeptical:
Mr. Robertson said . . . while he would not want to argue that the proposed
operations would be illegal, he thought that the point was highly
questionable (p. 805). . . . It seemed to him this whole problem was not
fundamentally the problem of the Federal Reserve, but rather of the Treasury.
If so, Federal Reserve operations of the kind suggested might be construed as
bailing out the Treasury. . . . Accordingly, before any
operations were undertaken, he felt that the Congress should have a chance to
take a look, at least through the Banking and Currency Committees, to see
whether it was felt that the Federal Reserve had the power to proceed. . . . In
other countries there was a much closer relationship between the central bank
and the executive branch of the Government than in this country. . . . While
this problem [weakness of the dollar] did exist, he would not want to see the
Federal Reserve take the position that it could construe the statute
[Section 14 of the Federal Reserve Act] in any way it wished (p. 806).
FOMC members then raised a variety of questions:
Mr. Swan [president of the San Francisco Fed] noticed . . . that the
Stabilization Fund had certain amounts committed under existing stabilization
agreements with Latin American countries, whereas presumably Federal Reserve
operation would not involve such uses of funds (p. 808). . . . Mr. Wayne
[president of the Richmond Fed] said . . . he would feel much more
comfortable if the Federal Reserve had an official commitment from the
Congress that operations of the kind under consideration were clearly within
its power (p. 809). . . . Mr. Allen said . . . he had some doubt about
the legality of Federal Reserve operations. . . . He was inclined to think
that the intent of Congress had been . . . to have the Stabilization Fund do
this job (p. 810).
4. BACKGROUND TO THE DEBATE
The Federal Reserve Act does not explicitly authorize the Fed to influence
the value of the dollar by intervening in the foreign exchange market or to
acquire foreign exchange for that purpose by swapping deposits with foreign
central banks (establish swap lines). It also does not explicitly authorize
the Fed to acquire foreign exchange from the Treasury (warehousing). This
omission of powers undoubtedly reflected the adherence of the authors of the
Federal Reserve Act to the two dominant assumptions of their era: the
discipline of the gold standard and the real bills doctrine. Adherence to the
gold standard (continued in the Bretton Woods system) required that the Fed
raise the discount rate in response to gold outflows. It seems unlikely
that the authors of the Federal Reserve Act would have authorized
actions designed to avoid this discipline. Also, according to the
real bills doctrine, a central bank should extend credit only through
discounting commercial bills (bills of exchange), that is, on the basis of
debt arising from the financing of real productive activity. Again, it seems unlikely
that the authors of the Federal Reserve Act would have authorized
deposit creation for U.S. and foreign governments in return for direct asset
sales. (Foreign central banks were typically under direct
government control.)
Section 14 of the Federal Reserve Act states “Any Federal reserve bank
may . . . purchase and sell in the open market, at home or abroad, either
from or to domestic or foreign banks, firms, corporations, or individuals,
cable transfers and bankers’ acceptances and bills of exchange.”
Given the existence of the gold standard and the acceptance of the real bills
philosophy at the time of the writing of the Federal Reserve Act, the
simplest understanding of the power to buy and sell foreign exchange (cable
transfers in the language of the Federal Reserve Act) would be as a power
facilitating transaction abroad by the Fed in gold or bankers’
acceptances and bills of exchange. H. Parker Willis (1926, p. 488), who
drafted the Federal Reserve Act for Carter Glass, discussed the intention of
this part of the Federal Reserve Act. He wrote that the power to deal in
cable transfers facilitated the ability of Reserve Banks to purchase gold
abroad. These foreign gold purchases could be used to supplement the domestic
stockpiles of the Reserve Banks. Such purchases could also be used to avoid
unnecessary trans-Atlantic movements of gold. For example, a Reserve Bank
could use its holdings of gold in London to meet the needs of an individual
in London wanting to exchange dollars for gold and thus avoid the need for shipment
of gold from New York.
The Federal Reserve Bank of New York had opened swap lines in the 1920s with
foreign central banks desiring to make their currencies convertible.5 In
1932, however, Carter Glass, senator from Virginia and author of the Federal
Reserve Act, denounced on the Senate floor those swap lines as
inconsistent with the Federal Reserve Act. As a consequence, in the
Banking Act of 1933, Congress added language to the Federal Reserve Act
giving the Board of Governors the power to prevent the New York Fed
from dealing directly with foreign banks. “. . . the Board
subsequently (in 1933 and 1934) construed section 14(e) as limiting foreign
accounts to the purchase of bills of exchange” (U.S. Congress 1962, p.
147).
5 Coombs (1976, p. 75) said of the swap arrangements he was discussing
with other central banks in January 1962, “Such swaps of one currency
for another, with a forward contract to reverse the transaction, say 90 days
hence, had long been a standard trading instrument in the foreign exchange
markets. Moreover, back in 1925, the New York Federal [Reserve Bank] under
Governor Strong had arranged with the Bank of England a similar swap
arrangement of $200 million of United States gold against sterling.”
5. DEBATING FED FOREIGN EXCHANGE INTERVENTION
At the request of Chairman Martin, Board Counsel Howard Hackley wrote a
memorandum outlining a legal basis for Fed participation in foreign exchange
operations. The FOMC discussed the memo at its December 5, 1961, meeting.
(The full memorandum is reprinted in U.S. Congress [1962]. Appendix B
summarizes the legal arguments of the memorandum.)
President Swan had already expressed his doubts in a November 30, 1961,
letter to Ralph Young (Foreign 1961). He argued that the memo was a “shaky
foundation for proceeding with a full-blown operation” because “the
real bills doctrine of the 1914 law” made it doubtful that the Federal
Reserve Act would authorize opening foreign accounts for purposes other than
buying bills of exchange. Most FOMC members shared the sentiments expressed
by George Clay (Board of Governors 1961, p. 1035), president of the Kansas
City Fed:
Mr. Clay went on to say that he had a basic feeling against Government
agencies taking unto themselves authorities that had never been specifically
granted. . . . He felt that Congress should be given an opportunity, and in
fact urged, to assign this authority to the agency that in its wisdom it
would choose.
Governor King (Board of Governors 1961, p. 1043) commented:
He did not think the Federal Reserve was the proper place for these
operations if they were to be conducted. Instead, he felt that a political
agency or body would be the proper place to lodge the responsibility. As he
had heard it said on various occasions, if the System should get into
politics at any stage it could founder.
President Bopp (Board of Governors 1961, p. 1046) stated:
Like others who had spoken, he was concerned about the legal basis for
System operations in foreign currencies. The legal authority was not based on
specific provisions of the law but rather on a construction of the statutes.
. . . In a democratic process it was important . . . to have specific
authorization.
President Bryan (Board of Governors 1961, pp. 1048–49) of the Atlanta
Fed urged the FOMC to concentrate on maintaining convertibility through the
appropriate domestic policies. “Sometimes . . . a great deal more
harm can be done, with good intentions, by intervening to save the patient
some pain than by letting him realize he is sick.”
Governor Robertson (Board of Governors 1961, pp. 1037–42) argued that sterilized
foreign exchange intervention by the Fed was bad law, bad politics, and bad
economics:
It does not follow that the power to maintain foreign
accounts—basically an incidental power—can be regarded as an
authorization to exercise the broad policy functions contemplated by the
instant proposal. In other words, even if foreign accounts may be maintained
in connection with functions other than dealing in bills of exchange, these
must be functions that are authorized by the Federal Reserve Act. Nowhere
in the Act can authority be found for the stabilization function that is the
core of this proposal (italics in original).
Even if its legality were to be assumed, I think the proposed action would be
highly questionable because it is inconsistent with explicit Congressional
authority. . . . Purchasing foreign exchange from the Stabilization Fund
whenever that fund has been used up or by operating in the same field
on its own . . . could be interpreted as circumventing the will of Congress
by making available more dollars for the purpose of “stabilizing the
exchange value of the dollar” than Congress contemplated. . . . Such a
function [selling foreign exchange] . . . involves very sensitive
international diplomatic relationships, with which the Federal Reserve is not
in the best position to cope. The function would seem to be more
appropriately one for the Treasury (which Congress has already designated to
handle the problem).
Federal Reserve operations in foreign currencies . . . would merely
camouflage the difficulty, which is one of dealing with the balance
of payments problem. . . . If the amount of that fund [the ESF] is
insufficient, then the Treasury should request Congress to expand the fund. .
. . There are no gimmicks by which the position of the dollar can be
maintained in the world. It would be unwise to resort to devices designed to
hide the real problems and assuage their symptomatic effects. . . . The
United States must practice what it has long preached about the need for
monetary and fiscal discipline.
6. THE DECISION TO INTERVENE
The main defenders of Fed involvement in the foreign exchange markets were
Governor Balderston, Charles Coombs, and President Hayes of the New York Fed.
Balderston (Board of Governors 1961, p. 1058) argued that the Fed should
intervene in the foreign exchange market because “it was so close to
the function carried on by the Open Market Committee in domestic
affairs.” Coombs (Board of Governors 1961, p. 1052) argued that
“speculative pressures could boil up within a matter of minutes in the
exchange market. . . . It would be desirable to have the resources to deal
with such periodic emergencies, so that exchange operations could resist speculative
trends before they had gone too far.” Hayes (Board of Governors
1961, p. 1054) argued that, since the ESF was not in a position to intervene
in foreign exchange markets, the Fed should do so.
As to the roles of the Treasury and Federal Reserve, some of those who
commented had suggested that the Stabilization Fund was set up for this kind
of purpose. Actually, however, the Fund had been used for a lot of other
purposes. It had been used to assist United States foreign policy in relation
to various weaker currencies that needed shoring up, as a kind of State
Department activity.
In a poll conducted by Chairman Martin, thirteen of the eighteen FOMC
participants registered the opinion that “legislation is
desirable” before beginning to intervene in the foreign exchange
market. (The poll is recorded in the notes of Richmond’s President
Wayne and are in the Richmond Fed archives for the December 5, 1961, FOMC
meeting.) One of the five in favor of intervention, Governor Mills,
expressed reservations. “He had no great faith that operations of this
kind could be conducted successfully or without serious danger to the
independent status of the Federal Reserve System.” Another of
the five in favor, Delos Johns, president of the St. Louis Fed, believed the
FOMC should seek enabling congressional legislation at the same time it
proceeded. Chairman Martin ended the meeting by saying that he would explore
the matter of legislation with the Treasury and report back to the Committee
at its next meeting.
At the December 19, 1961, FOMC meeting, Chairman Martin, supported by
President Hayes, asked the Committee’s permission to discuss a working
relationship with the Treasury for foreign exchange intervention.6 Most
members agreed that Chairman Martin should continue discussions with the
Treasury, but agreed with President Deming of the Minneapolis Fed “that
he would regard operations in foreign currencies as a proper activity for the
central bank if statutory clarification could be obtained” (Board of
Governors 1962, p. 1151).
At the January 9, 1962, FOMC meeting, Chairman Martin asked Hackley to report
to the FOMC on his discussions with the Treasury’s general counsel,
Robert Knight. Hackley noted that the Treasury’s general counsel and
the Attorney General concurred with his opinion. He also noted that the
Treasury opposed seeking legislation for three reasons (Board of
Governors 1962, p. 61):
The international situation was very tender. . . . If there were discussions
on the Hill, they might be agitating to the markets. Second . . . it might be
better to seek such legislation after the Open Market Committee had some
experience in order to determine what its problems and limitations were. . .
. Third, there was a range of ideas on the Hill with regard to the Federal Reserve
System. . . . Legislation, if sought, might become a vehicle for adding
various amendments the nature of which could not be foretold.
Chairman Martin said that he had conferred with the Secretary of the
Treasury, and they agreed that “regarding the question of seeking
legislation . . . there were real problems involved.” Martin suggested
that he confer with the chairmen of the House and Senate Banking Committees.
“If the Committee Chairmen . . . should feel strongly that the
introduction of legislation would cause a great deal of stir, it might be
better not to embark on that course” (Board of Governors 1962, p.
63). Governor King then commented
The Federal Reserve was being asked to go a little too far in the
name of cooperation. As he understood it, the Treasury was
suggesting that it might not favor legislation because of apprehension as to
the outcome (p. 63). [Exactly]
The Committee then authorized Chairman Martin to confer with the chairmen of
the congressional banking committees.
At the January 23, 1962, meeting Chairman Martin reported to the FOMC
“on the general problem of obtaining legislation that would clarify the
Committee’s authority to conduct foreign currency operations.”
Although the Minutes do not explain why, Chairman Martin no longer
considered legislation an option. The Minutes note then that the
FOMC had a roundtable discussion. They record a reference to the opinions of
the Committee’s and Treasury’s general counsels that the
“System’s existing statutory authority, although in some respects
limiting, did provide a general sanction for Committee operations,” but
otherwise state only that “differing viewpoints were expressed.”
The Minutes (Board of Governors 1962, pp. 111–12) then state
6 On December 18 the Secretary of the Treasury had sent a letter to
Chairman Martin asking for prompt resolution of the issue of FOMC involvement
in foreign exchange intervention and offering the advice of the
Treasury’s legal staff. “I realize that the Committee might
be hesitant to embark on operations in which it has not engaged since the
establishment of the Stabilization Fund under the Gold Reserve Act of 1934. If
the Committee should be interested in the opinion of the Treasury’s
General Counsel . . . the Treasury’s legal staff will be ready to
cooperate with yours” (Board of Governors 1961, p. 1146).
In bringing the discussion to a head, it was moved by Mr. Balderston and
seconded by Mr. Hayes that the Committee go on record at this session as
favoring in principle the Committee’s initiation on an experimental
basis of a program of foreign currency operations; that Mr. Young, the
Committee’s Secretary, and Mr. Coombs, Vice President in charge of
foreign operations of the New York Federal Reserve Bank, be authorized to
explore for the Committee with the Treasury the needed guidelines for actual
operations . . . and further that Chairman Martin be authorized to refer to
this development in his statement and testimony before the Joint Economic
Committee scheduled for January 30, 1962.
Ten of the twelve voting FOMC members voted in favor and two (Governors
Robertson and Mitchell) dissented.
At its February 13, 1962, meeting, the FOMC discussed the issue of “the
needed guidelines for actual operation.” The exchange was charged
because it dealt with the issue of Fed independence. Because foreign exchange
intervention involved U.S. relations with foreign governments, many FOMC
members were afraid that the Fed would inevitably become a junior member to
the Treasury. Earlier, in a November 30, 1961, letter to Ralph Young,
President Fulton of the Cleveland Fed (Foreign 1961) had written
There is a danger that if the System takes on the functions of the
executive, it will end up as a captive of the executive branch of the
government. . . . It might be safer for the Congress to designate
the Treasury Department as the principal locus of responsibility for exchange
operations. . . . This approach . . . would not rely on a tenuous
Treasury-Federal Reserve “accord,” which might not endure with different
personalities and under different conditions. For another thing, Congress
would retain its traditional control over the purse strings.
At the February 13 meeting, Governor King argued for explicit assurance
that the Fed could refuse to finance the activities of the ESF (Board
of Governors 1962, pp. 175–77):
Mr. King raised a question with respect to the comment made earlier by Mr.
Young that there would be no specific rules at the outset on relationships
between the Treasury and the Federal Reserve, the thought being that these
might evolve out of experience. He asked whether it might not be better to
have such rules.
In response, Mr. Young expressed the view that no general rule was needed. .
. . He did not think that the Treasury would be apt to come to the System
with the idea of selling from the Stabilization Fund unless something
happened in the development of the over-all program of foreign currency
operations that would make it seem desirable, from the Treasury’s
standpoint, to get unloaded. There could always be that development. For
example, an underdeveloped country might need temporary help and there would
be no way to arrange it except to give a commitment from the Stabilization
Fund. In that event, the Treasury might need to convert some of its resources.
Mr. Robertson inquired as to the advantages seen—aside from the Federal
Reserve’s “unlimited pocketbook”—in having two
agencies operating in this field instead of one, and Mr. Coombs replied that
he did not think there were any. . . . He [President Swan] asked whether
it was not possible that the Federal Reserve would just be in the role of
supplying funds to the Treasury rather than conducting foreign currency
operations.
[Chairman Martin] considered it difficult to sit down and attempt to draw up such
principles while the Federal Reserve was in the process of learning.
Chairman Martin then advanced a proposal that the Board of Governors, not the
full FOMC, have responsibility for foreign exchange intervention. Hackley
explained the proposal, which he had advanced in a memo dated February 8,
1962: “He [Hackley] did feel that in at least some respects this
approach might be more defensible from a legal standpoint” (Board of
Governors 1962, p. 177). The New York Fed and many other regional banks, however,
objected to being excluded. Most FOMC members felt that exclusion of the
regional banks would weaken the federal character of the System:
[Governor] Shepardson said that . . . either approach involved an
interpretation of the law that was rather nebulous. . . . On the assumption
that the original proposal would be legally supportable . . . participation
of the entire Open Market Committee would be desirable from the standpoint of
System unity (Board of Governors 1962, p. 186).
As part of this discussion, Chairman Martin recommended that decisions about
foreign exchange intervention be made by a subcommittee consisting of the
Chairman and Vice Chairman of the FOMC and the Vice Chairman of the Board of
Governors. Earlier, Delos Johns (Board of Governors 1961, p. 1051), president
of the St. Louis Fed, had opposed such a delegation of authority:
He had real doubt about the power of the Committee to delegate its
responsibilities. That was an old question. . . . He was not quite satisfied
by the argument that a subcommittee that supervised the operations was not
making policy. The executive committee was abolished because the Committee
became convinced that it was not confining its activities to administration
and instead was actually making policy. This is almost inevitably the result,
he suggested, when delegations of authority are made to a small group.7
7 Prior to 1955, only the Executive Committee (consisting of the Fed
chairman, two governors, the president of the New York Fed, and one other
regional Bank president) met regularly to make monetary policy. The full FOMC
met only four times a year, with two of those meetings separated by only a
weekend.
There was, however, no real opposition to delegating to a small
subcommittee authority over operations in the foreign exchange markets. Any
other arrangement appeared impractical.
Chairman Martin then asked for approval of guidelines for initiating foreign
currency purchases. Although the Board staff had circulated on December 12,
1961 (Foreign 1961), a draft of congressional legislation that would give the
Federal Reserve explicit authority to transact in foreign exchange, Martin
(Board of Governors 1962, p. 193) argued
There were those . . . who felt that the law was not sufficiently clear. It
might be desirable to seek legislation in this area at some time, but at the
moment he doubted whether it would be feasible, with so little experience, to
determine what kind of legislation was needed. . . . The availability of
those decisions [Hackley’s memorandum and the opinions of the
Treasury’s general counsel and the Attorney General], along with a lack
of System experience in foreign currency operations, would handicap the
System if it tried to get legislation. The System would be asked what kind of
additional legislation it needed, and the Congress probably would not want to
put itself in the position of approving something if the Federal Reserve was
not clear about its wishes in the matter.
In the words of Coombs (1976, p. 72), the FOMC then “somewhat apprehensively
approved on February 13, 1962, the undertaking of market operations in
foreign currencies.”
At the March 6, 1962, FOMC meeting, discussion again centered around the
issue of whether the Fed, by participating in foreign exchange operations, would
be taking orders from the Treasury [Answer: yes]. The Treasury had
two immediate problems. First, a number of foreign governments, especially
France, wanted gold for their dollars. The problem was acute:
Mr. Coombs reiterated that a number of European central banks holding large
amounts of dollars had been deliberately refraining from taking gold. If any
bank should come in for a large amount of gold, an “every man for
himself” proposition could possibly develop (Board of Governors 1962, p.
273).
On February 28, in a telephone poll, the FOMC had approved entering
into a swap arrangement with France.8 Among the seven governors, King
and Robertson had dissented and Mitchell had abstained.
8 See the discussion in the appendix in the memo of Ralph Young, dated
October 17, 1963, on using swaps to offer foreign central banks protection
against dollar devaluation.
The Treasury’s second problem was that the ESF needed dollars so it
could buy Swiss francs to meet its forward commitments:
Mr. Mitchell inquired of Mr. Coombs whether a purchase by the System of
marks from the Stabilization Fund might not be the kind of operation that
would leave the System open to the charge of bailing out the Stabilization
Fund. . . . At times [Always]. . . the Federal Reserve had
been dominated by the Treasury, so there
was always a problem of maintaining a kind of arms-length relationship. On
the present occasion, the objectives of the Treasury and the Federal Reserve
tended to coincide, but a different situation could possibly develop
(Board of Governors 1962, pp. 277 and 280).
Reference was made by Mr. Thomas [Board economist] to the fact that the
Federal Reserve could not purchase U.S. government securities directly from
the Treasury. . . . Mr. Hackley [said] that the law clearly indicates that
direct purchases of U.S. government securities from the Treasury are not open
market transactions. As to foreign currency operations, he had come to the
conclusion, however, that in this sense the Stabilization Fund was a part of
the open market (Board of Governors 1962, pp. 279 and 283).
After Coombs noted that “the Stabilization Fund was strained to the
utmost at this moment” (Board of Governors 1962, p. 285), the Committee
voted to buy marks from the ESF.
7. CONGRESSIONAL ANNOUNCEMENT
On February 27 and 28, 1962, the House Committee on Banking and Currency
held hearings on legislation (U.S. Congress 1962) to increase the resources
of the IMF. Chairman Martin (U.S. Congress 1962, pp. 91–92) used these
hearings to announce that the Federal Reserve had become involved in foreign
exchange intervention:
The Federal Reserve has recently acquired small amounts of several
convertible currencies widely used in international transactions from the
Treasury Stabilization Fund and has opened accounts with several European
reserve banks. . . . While in time it may be desirable to recommend amendment
of the Federal Reserve Act to provide greater flexibility than we now have
under the act in carrying out these operations, it would be impractical to
request such legislation before operating experience under existing authority
has provided a clear guide as to the need for it.
Rep. Reuss (U.S. Congress 1962, pp. 102 and 140) criticized the use of the
“nearly unlimited money creative powers of the system” to
intervene in the foreign exchange markets:
Much of the operation that you are doing . . . seems to me to duplicate the
foreign exchange stabilization operation that the Secretary of the Treasury
has very properly undertaken pursuant to the Gold Reserve Act of 1934. To me this
is a tremendous power you have taken upon yourself, and I must serve notice
on you right now that I consider this an usurpation of the powers of
Congress. . . . You come in here and tell us that you propose to go
off on, if I may say so, a frolic of your own, involving unspecified sums
without the slightest statutory guidance.
Chairman Martin (U.S. Congress 1962, p. 140) challenged Rep. Reuss’
representation. “Now, you may disagree as a lawyer with the lawyers for
the Federal Reserve Board as to our existing authority on this, Mr. Reuss.
But as I reiterate, our lawyers said we had the authority, the Treasury
counsel concurred, and the Attorney General concurred with them.”
Copies of the Hackley Memorandum, the opinion of the Treasury’s general
counsel and the concurrence of the Attorney General were provided to the
Committee at its request and published in the hearing record.9
8. CONCLUDING COMMENTS
From the time of the first swap arrangement with France for $50 million in
1962 to the closing of the gold window in August 1971, Fed swap lines grew to
$11.7 billion. The entrance of the Fed into the foreign exchange markets
initially produced considerable internal debate. On the one hand, Coombs
(1962, p. 469) considered foreign exchange intervention to be integral to
maintaining the international monetary order. “[W]hen the exchange
markets become seriously unsettled by political or other economic
uncertainties, normally beneficial speculation may quickly become transformed
into a perverse, and sometimes even sinister, force.” On the other
hand, Governor Robertson (Board of Governors 1962, p. 185) was critical:
9 The Fed’s conduct of foreign exchange operations has continued to be
the subject of much discussion in the years since the internal FOMC debate
chronicled in this article. In commenting on an earlier draft of this
article, members of the Board of Governors’ staff suggested that the
following additional information be included for completeness:
Since 1962, Congress has reviewed the foreign currency operations of the
Federal Reserve in hearings on related issues. The Hackley Memorandum was
published a second time in a 1973 hearing record of the House Banking
Committee on the Par Value Modification Act of 1972. In addition, the Annual
Reports of the Board have described and provided data on the Federal
Reserve’s foreign currency operations, and the Federal Reserve Bank of
New York has submitted quarterly reports to Congress on Treasury and Federal
Reserve foreign currency operations. Although Congress can properly be
considered to have been fully aware of these published materials, it has not
acted to restrict the authority of the Federal Reserve to engage in these
operations.
In fact, Congress has recognized and facilitated the Federal Reserve’s
foreign currency operations by amending a related provision of the Federal
Reserve Act to permit the investment of foreign exchange obtained through
those operations. In 1980, Congress amended Section 14(b)(1) of the Act to
grant Reserve Banks the authority to invest foreign exchange in
“short-term foreign government securities.” The provision was
enacted as part of the Monetary Control Act of 1980 in response to a
long-standing request from the Board. Its enactment demonstrated congressional
awareness and suggested tacit acceptance of the Federal Reserve’s
foreign currency operations.
Finally, in 1989 and 1990 the Federal Reserve conducted a comprehensive study
and review of System foreign exchange operations. This material was discussed
and reviewed by the FOMC at its meeting on March 27, 1990. All aspects of the
operations, including the policy and legal basis of such operations, were
thoroughly examined. After consideration of the material, the FOMC voted
in favor of increasing the limits on the System’s holding of foreign
currencies and on the amount of eligible foreign currencies the System was
willing to warehouse for the Treasury and the ESF. The discussion and the
votes were reported in the published FOMC minutes. Three members dissented
from these decisions. Two of the dissenters cited concerns about the absence
of definitive congressional intent in this area but only in reference to the
warehousing increase.
Mr. Robertson recalled that he had opposed the whole program of operations
in foreign currencies on legal, practical, and policy grounds because it had
seemed to him that the only basis for the entrance of the Federal Reserve
into this field would be to supplement the resources of the Stabilization
Fund and because the program was being undertaken without specific
congressional approval.
The place of the Federal Reserve System within the U.S. government is
different from the place of central banks in other countries because the U.S.
government is different. The U.S. government is characterized by a
division of powers, with fiscal policy assigned to Congress. As discussed
in Appendix A and Broaddus and Goodfriend (1995), the sterilized foreign
exchange intervention and warehousing practiced by the Fed since the early
1960s constitute fiscal policy, not monetary policy. That fact
raises fundamental issues about the Fed’s operations in the foreign
exchange markets. Policymakers vigorously debated many of these issues
when the Fed first became involved in the foreign exchange markets in the
early 1960s. Those debates remain helpful today in assessing the proper role
of the Federal Reserve System.
APPENDIX A: SWAPS AND WAREHOUSING
The Fed can obtain the foreign exchange it requires to buy dollars in the
foreign exchange market through a swap of currencies with another central
bank. In a swap, the Fed agrees to establish dollar deposits on its books for
the German Bundesbank in exchange for the Bundesbank establishing mark
deposits for the Fed. At the same time, the Fed agrees via a forward
transaction to reexchange the same amount of marks for the Bundesbank’s
dollars at a given date in the future. Before the breakdown of the Bretton
Woods system of fixed exchange rates, the United States used swaps to provide
cover for the dollar holdings of foreign central banks. That is, as a
consequence of maintaining the fixed exchange rate with the dollar, the
Bundesbank might have to buy dollars it did not want to hold. It would have
liked to exchange them for gold at the U.S. Treasury, but the Treasury did
not want to deplete its stockpile of gold.
The U.S. Treasury could persuade the Bundesbank to hold the unwanted dollars by
guaranteeing the Bundesbank against loss in case of a devaluation of the
dollar. The Treasury did so by having the Fed take marks acquired by
the latter in a swap transaction and use them to buy dollars from the
Bundesbank. Counting the dollars in its swap account, the Bundesbank ended up
with the same amount of dollars as before the swap, but more of the dollars
it did hold were protected against devaluation. The reason is that if the
Bundesbank decided not to renew the swap agreement, it could just exchange at
the old exchange rate its dollars at the Fed for the marks in the Fed’s
deposit at the Bundesbank. The Fed, however, since it had used its marks to
buy the Bundesbank’s dollars, would have to go into the market to
buy the marks. (In practice, the Treasury always protected the Fed
from loss in buying the necessary foreign exchange.)
Ralph Young (1963; Swap), Director of the Board’s Division of
International Finance, provided the following explanation:
Foreign monetary authorities were increasingly unwilling to hold additional
dollar claims on an uncovered basis. . . . When the System draws foreign
currencies for temporary use under a swap arrangement, the foreign central
bank comes into additional dollar holdings that are covered against exchange
risk in an amount corresponding to the System’s drawing. As the
System uses the currencies that it has drawn . . . through a direct sale
against dollars with the foreign monetary authority, the uncovered dollar
holdings of the foreign monetary authority are reduced . . . by a
corresponding amount. In this way, although the foreign central bank in
question ends up holding the same amount of total liquid dollar assets that
it would have held in the absence of the swap drawing . . . its uncovered dollar
holdings can be held down to the amount that . . . it is content to hold. And
in this way, gold sales by the U.S. Treasury are avoided (italics in
original).
After the breakdown of the fixed parities of the Bretton Woods system in the
early 1970s, the Fed began using the foreign exchange acquired in swap
transactions to intervene directly in the foreign exchange markets in
response to weakness in the external value of the dollar. At that time, swaps
assumed their more modern function of attempting to influence market
psychology. Charles Coombs (Board of Governors 1971), Manager of the System
foreign exchange account, and Fed Chairman Arthur Burns (Board of Governors
1972), respectively, expressed the change:
Mr. Coombs remarked that the rationale of the swap network rested on two
main considerations. First, the network enabled the System to shield the
Treasury gold stock and other reserve assets by providing the alternative of
an exchange guarantee to foreign central banks having dollars they wished to
convert. . . . That part of the rationale had now fallen away, since the
decision of August 15 [1971, closing the gold window] had made the dollar
inconvertible into gold or other reserve assets (p. 1101). . . . More
generally, the swap network had come to be regarded in the market as the very
symbol of central bank cooperation (p. 1102).
By demonstrating that the United States was prepared to cooperate with other
nations . . . such operations [in the foreign exchange markets] could have a
major impact on market psychology (pp. 734–35).
Swaps constitute a fiscal policy, not a monetary policy, action. (See
Goodfriend and King [1988] on monetary and fiscal policy.) Consider a swap
line with Mexico that involves the acquisition of peso deposits by the Fed in
return for dollar deposits at the Mexican central bank. If the Mexican
central bank tries to prop up the value of its currency by using its dollar
deposits to buy pesos on the foreign exchanges, the U.S. monetary base
increases. The Fed will sterilize this increase in the base by selling U.S.
Treasury securities out of its portfolio. As a result, the Fed’s
portfolio will come to include fewer U.S. assets and more peso assets.
Because the monetary base ends up unchanged, the Fed has not undertaken a
monetary policy action. Neither the U.S. money stock nor interest rates
changes. However, when the Fed sells Treasury securities, the supply of U.S.
Treasury securities in the hands of the public increases. The effect is
the same as though the Treasury had lent money to Mexico by selling Treasury
securities to the general public. The Fed has undertaken a fiscal
policy action. [important point]
Warehousing is one way the Treasury obtains funds for either intervening
in the foreign exchange market or lending to a foreign government. It also
involves a fiscal policy action by the Fed (Goodfriend 1994). With warehousing,
the Fed puts dollars into a deposit account of the U.S. Treasury in return
for assets denominated in foreign currencies from the Treasury. At the same
time, the Fed and the Treasury agree to reverse the transaction at a future
date. Warehousing is equivalent to a repurchase agreement in which the Fed
makes a loan to the Treasury using the foreign assets as collateral. When the
Treasury uses the dollars it has gained to intervene in the foreign exchange
market, the Fed offsets the resulting increase in the monetary base by
selling a Treasury security. As above, government debt in the hands of the
public increases. It is as if the Treasury issued debt to obtain
dollars with which to buy foreign exchange. [important point]
If the Fed provides a loan to Mexico via a swap or to the Treasury via
warehousing, the measured federal government deficit does not rise
because for accounting purposes the Fed is assumed to be part of the private
sector. [important point] What is relevant for fiscal policy,
however, is government debt in the hands of the taxpaying public. If the Fed
acquires an additional government security, it will return the interest it
receives to the Treasury. Interest paid on the debt is a wash. In contrast,
if the private sector acquires an additional government security, the U.S.
government must come up with additional funds to pay the interest. Swap
lines and warehousing that finance sterilized foreign exchange intervention
are fiscal policy actions because they increase the debt that taxpayers must
fund.10
10 The additional interest the Treasury owes because of the increase in its
debt outstanding can be offset by the interest gained on the acquisition of a
foreign asset. The redistribution of assets, however, is still fiscal policy.
With warehousing or a swap, the Fed has extended credit to the Treasury or a
foreign government, but has not changed the monetary base.
Eric
de Carbonnel
Market Skeptics
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