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U.S. Foreign Exchange Intervention

The U.S. monetary authorities occasionally intervene in the foreign exchange (FX)market to counter disorderly market conditions.

The Treasury, in consultation with the Federal Reserve System, has responsibilityfor setting U.S. exchange rate policy, while the Federal Reserve Bank New York is

responsible for executing FX intervention.

U.S. FX intervention has become less frequent in recent years.Purpose of Foreign Exchange InterventionThe Department of the Treasury and the Federal Reserve, which are the U.S. monetaryauthorities, occasionally intervene in the foreign exchange (FX) market to counter disorderlymarket conditions. Since the breakdown of the Bretton Woods system in 1971, the United Stateshas used FX intervention both to slow rapid exchange rate moves and to signal the U.S.monetary authorities' view that the exchange rate did not reflect fundamental economicconditions. U.S. FX intervention became much less frequent in the late 1990s. The United Statesintervened in the FX market on eight different days in 1995, but only twice from August 1995through December 2006.

Scope of the FX MarketThe foreign exchange market is a network of financial institutions and brokers in whichindividuals, businesses, banks and governments buy and sell the currencies of different countries.They do so in order to finance international trade, invest or do business abroad, or speculate oncurrency price changes. On average, the equivalent of about $1.9 trillion in different currencies istraded daily in the FX market around the world.

There are two primary types of transactions in the FX market. An agreement to buy or sellcurrency at the current exchange rate is known as a spot transaction. By convention, spottransactions 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 sellcurrencies for settlement at least three days later, at predetermined exchange rates. This secondtype of transaction often is used by businesses to reduce their exchange rate risk.

The Effects of Exchange Rate ChangesAn exchange rate is the price of one foreign currency in terms of another currency. Foreignexchange rates are of particular concern to governments because changes in FX rates affect the

value of products and financial instruments. As a result, unexpected or large changes can affectthe health of nations' markets and financial systems. Exchange rate changes also impact anations international investment flows, as well as export and import prices. These factors, inturn, can influence inflation and economic growth.

For example, suppose the price of the Japanese yen moves from 120 yen per dollar to 110 yenper dollar over the course of a few weeks. In market parlance, the yen is "strengthening" orappreciating against the dollar, which means it is becoming more expensive in dollar terms. If

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the new exchange rate persists, it will lead to several related effects. First, Japanese exports tothe United States will become more expensive. Over time, this might cause export volumes tothe 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 influenceexchange rates. Money tends to flow into investments in countries with relatively high real (thatis, inflation-adjusted) interest rates, increasing the demand for the currencies of these countriesand, thereby, their value in the FX market.

The Role of the Federal ReserveCongress has assigned the U.S. Treasury primary responsibility for international financial policy.In practice, though, the Treasury's FX decisions typically are made in consultation with theFederal Reserve System. If the monetary authorities elect to intervene in the FX market, the

intervention is conducted by the Federal Reserve Bank of New York. When a decision is made tosupport the dollars' price against another currency, the foreign exchange trading desk of the NewYork Fed buys dollars and sells the foreign currency; conversely, to reduce the value of thedollar, it sells dollars and buys the foreign currency. While the Fed's trading staff may operate inthe FX market at any time and in any market in the world, the focus of activity usually is theU.S. market.

Because the Fed's purchases or sales of dollars are small compared with the total volume ofdollar 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. foreignexchange intervention is used as a device to signal a desired exchange rate movement.

The Intervention ProcessThe foreign currencies that are used to intervene usually come equally from Federal Reserveholdings and the Exchange Stabilization Fund of the Treasury. These holdings currently consistof euros and Japanese yen. Interventions may be coordinated with other central banks, especiallywith the central bank of the country whose currency is being used.

In recent years, the Federal Reserve and the Treasury have made their interventions moretransparent. Thus, the New York Fed often deals directly with many large interbank dealerssimultaneously to buy and sell currencies in the spot exchange rate market. The Fed historicallyhas not engaged in forward or other derivative transactions. The Treasury Secretary typicallyconfirms 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 theTreasury's confirmation of intervention activity.

The Federal Reserve routinely "sterilizes" intervention in the FX market, which prevents theintervention from changing the amount of bank reserves from levels consistent with establishedmonetary 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

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domestic open market transactions, may remove reserves through the sale of governmentsecurities.

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 FederalReserve Foreign Exchange Operations".

Not all New York Fed trading desk activities in the market are directed by the TreasuryDepartment or Federal Reserve. On occasion, the New York Fed may act as agent on behalf ofother central banks and international organizations wishing to participate in the FX market in theUnited States, with no money of U.S. monetary authorities involved. The foreign central bankuses 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 toreflect any policy initiative of the U.S. monetary authorities. When the Federal Reserve buys andsells currencies on behalf of foreign central banks, the aggregate level of bank reserves does not

change, and sterilization is not needed.

May 2007