Page 1 of 4 The Fed and the strong dollar policy
By Henry C K Liu
A misleading impression has been given by recent press reports that the June 3
speech by Federal Reserve Chairman Ben Bernanke marked a Federal Reserve
departure from a long tradition of nonintervention on the exchange value of the
dollar, in response to the Treasury's renewed declaration that a strong dollar
is in the national interest of the US.
The reality is that the Fed has a long tradition in supporting the lead of the
Treasury in intervening on the exchange value of the dollar, albeit not always
to keep the dollar strong. The Exchange Stabilization Fund (ESF) was
established at the Treasury Department by the Gold Reserve Act of 1934 as part
of the New Deal. Section 7 of the Bretton Woods Agreements Act of 1945 as
signed by 28 nations obliged members to make subscription payments in gold or
equivalent currencies for shares in the International Bank for Reconstruction
and Development (World Bank). It required an amendment to the Federal Reserve
Bank Act of 1913 to maintain the exchange value of the dollar, making ESF
operations permanent.
Since then, the ESF has managed a portfolio of domestic and foreign currencies
for the purpose of foreign exchange intervention to allow the US to influence
the exchange rate of the dollar without directly affecting the domestic money
supply. The ESF holds of three types of assets: dollars, foreign currencies,
and Special Drawing Rights (SDRs) in the International Monetary Fund (IMF). As
of April 30, 2008, the ESF was holding assets totaling US$51.2 billion of which
$40.8 billion was retained profit.
By law, the Secretary of the Treasury is the chief international monetary
policy official of the United States. The Federal Reserve has separate legal
authority to engage in foreign exchange operations. Federal Reserve foreign
exchange operations are conducted in close and continuous consultation and
cooperation with the Treasury Secretary to ensure consistency with US
international monetary and financial policy.
The Treasury and the Fed have closely coordinated their foreign exchange
operations since early 1962, when the Federal Reserve commenced such operations
at the request of the Treasury. Operations are conducted through the Federal
Reserve Bank of New York, as fiscal agent of the US and as the operating arm of
the Federal Reserve System. Beginning in 1962, the Federal Reserve established
a network of reciprocal currency agreements (swap facilities) with major
foreign central banks and the Bank for International Settlements. In 1963, the
Federal Reserve authorized the "warehousing" of foreign currencies for the ESF.
By temporarily selling some of its foreign currency holdings to the Federal
Reserve for dollars through warehousing, the ESF was able to continue to
purchase foreign currencies even after it exhausted its initial dollar
resources.
In establishing the Bretton Woods system, the Articles of Agreement of the IMF
heavily stressed exchange rate stability. The intent was to discourage the
competitive devaluations that were viewed as contributing to economic and
financial chaos in the 1920s and 1930s. The Articles formally permitted
adjustment of a currency’s par value only if the country’s balance of payments
was in "fundamental disequilibrium". This came to mean that exchange rates
would be adjusted only as a last resort and only in conjunction with other
policies to redress the disequilibrium.
The expanding post-war world economy generated a secular increase in the demand
for international reserves in the form of dollars and gold. That demand had
been met through the early 1960s by a buildup of official claims on the US as
foreign monetary authorities intervened to maintain the value of their
currencies against the dollar. Gold and foreign exchange reserves of the
foreign G-10 countries tripled over the Bretton Woods period (1945-71), but
this increase was not matched by a rise in the US gold stock. Hence, confidence
in the ability of the US to meet calls on its gold stock declined. Thus
reliance solely on increases in US liabilities to foreign official institutions
for an increase in world reserves was seen to be inconsistent in the long run
with maintaining the convertibility of the dollar into gold at a fixed rate.
To relieve this fundamental tension, the US sought to preserve its gold stock
and the stability of the Bretton Woods system by creating an elastic reserve
asset whose supply could be systematically increased as the world economy
expanded. This resulted in an agreement to create IMF SDRs through the First
Amendment to the IMF Articles of Agreement, which was adopted in 1968 and
became effective the following year. The first allocation of SDRs was made in
January 1970.
Imports surcharge
President Richard Nixon, on August 15, 1971, suspended convertibility of
dollars into gold or other reserve assets for foreign monetary authorities. He
also announced a temporary 10% surcharge on imports to ensure "that American
products will not be at a disadvantage because of unfair exchange rates" and a
10% tax credit to businesses that invested in American-made equipment (the job
development credit). Use of the Federal Reserve swap network was suspended
after the closing of the gold window. Foreign authorities then had the choice
of continuing to pile up dollars in their official reserves that were now
inconvertible into gold or allowing their currencies to appreciate. The US no
longer intervened in the market to support an overvalued dollar.
By the end of August, all major currencies except the French franc were
floating. As selling pressure on the dollar mounted, the US in July 1972
resumed limited sales of foreign currencies and the swap network to defend the
dollar's Smithsonian parities, a system of fixed parities among the currencies
of the G-10 countries re-established through a negotiated realignment of
exchange rates in the Smithsonian Agreement of December 1971.
The dollar was devalued in terms of gold from $35 to $38 per ounce; other
currencies generally were revalued against the dollar by varying amounts. These
changes in parities resulted in an effective devaluation of the dollar of
nearly 10% on average against the other G-10 currencies. But the amount of the
devaluation fell short of US government estimates of what would be required to
restore the US external position to a sustainable balance. Floating was finally
legitimatized at the November 1975 Rambouillet Economic Summit among the major
industrial countries.
As the depreciation of the dollar intensified around the turn of the year, the
Federal Reserve responded by raising its discount rate in January 1978 to 6.5%,
citing developments in foreign exchange markets. However, the pace of US
inflation quickened to 9% in 1978, in part reflecting the past depreciation of
the dollar; meanwhile, inflation in the other G-10 countries, on average,
declined from 5.5% in 1975 to slightly more than 4% in 1978. Efforts to reduce
the US trade deficit by curbing oil imports after the crisis of 1973 were
unsuccessful. The Federal Reserve engineered further firming in money market
conditions through the spring and summer of 1978, but the growth of M1 still
exceeded its targeted range and the dollar continued to fall.
Disorderly conditions in exchange markets and a serious US inflation problem
forced the Federal Reserve in August 1978 to raise its discount rate 0.5
percentage point further to 7.75%. This move and subsequent increases in the
autumn provided only temporary support for the dollar. Between May and October
1978, president Jimmy Carter announced a series of measures to fight inflation,
including delays and reductions in the amount of scheduled tax cuts, budgetary
restraints, and voluntary wage-price guidelines.
Following the announcement of the last two measures in October, the dollar
tumbled still further, hitting on October 30 a record low on the trade-weighted
index compiled by the Federal Reserve Board staff. Two days later, a
dollar-defense package was announced. It included a further hike in the
discount rate by an unprecedented full percentage point, to a then historic
high of 9.5%.
In January 1978, the Treasury stated that the ESF would henceforth be used as
an active partner in the financing of intervention, and that a new swap line
with the Bundesbank had been established. Furthermore, in March, the Federal
Reserve’s swap line with the Bundesbank was doubled, and the Treasury sold SDRs
to the German central bank for marks. The Treasury also indicated that it was
prepared to draw on its reserve position at the IMF to acquire foreign
currencies.
To further support the dollar, the Treasury announced in May that it would
resume auctioning gold to the public. Finally, as part of the November 1, 1978,
dollar-defense program, a $30 billion package of foreign currency resources to
finance US intervention in cooperation with foreign authorities was put
together. It consisted of an increase in Federal Reserve swap lines with the
central banks of Germany, Japan, and Switzerland; sales of SDRs; a drawing on
the US reserve position at the IMF by the Treasury; and issuance of Carter
Bonds. US energy policy was widely regarded in exchange markets as being in
disarray. The subsequent dismissal of his cabinet by Carter raised concerns in
exchange markets about political leadership. Under these circumstances, US
authorities intervened substantially during the summer of 1979 to resist the
dollar’s decline.
In early 1981, the new Reagan Administration decided to move away from what it
judged to have been unwise intervention inherited from the previous
administration, reflecting the ideological view that exchange rates were the
product of national economic policies and that a multinational "convergence" of
economic policies was the way to stabilize exchange rates, a view consistent
with the Administration’s general desire to minimize government interference in
markets. The market was deemed to know best.
As the dollar rose due to complex interactions of divergent policies of
different governments, the Reagan Administration in its second term began to
reverse its policy of nonintervention in currency markets. Group of Five (G-5)
officials, meeting on January 22, 1985, issued a statement paying lip service
to their continuing commitment to promote the convergence of national economic
policies, to remove structural rigidities, and (as agreed at the Williamsburg
Economic Summit of April 1983) to undertake coordinated intervention in
exchange markets as necessary.
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