Tuesday, April 21, 2015

The Federal Reserve System of the USA and Central Banks of the Other G-7 Countries

The Federal Reserve System of the USA
Like the other central banks, the Federal Reserve of the USA affects the
foreign exchange markets in three general areas:
• the discount rate;
• the money market instruments;
• foreign exchange operations.
For the foreign exchange operations most significant are repurchase
agreements to sell the same security back at the same price at a predetermined
date in the future (usually within 15 days), and at a specific rate of interest. This
arrangement amounts to a temporary injection of reserves into the banking
system. The impact on the foreign exchange market is that the dollar should
weaken. The repurchase agreements may be either customer repos or system
Matched sale-purchase agreements are just the opposite of repurchase
agreements. When executing a matched sale-purchase agreement, the Fed sells
a security for immediate delivery to a dealer or a foreign central bank, with the
agreement to buy back the same security at the same price at a predetermined
time in the future (generally within 7 days). This arrangement amounts to a
temporary drain of reserves. The impact on the foreign exchange market is that
the dollar should strengthen.
The major central banks are involved in foreign exchange operations in
more ways than intervening in the open market. Their operations include payments
among central banks or to international agencies. In addition, the Federal Reserve
has entered a series of currency swap arrangements with other central banks since
1962. For instance, to help the allied war effort against Iraq's invasion of Kuwait in
1990-1991, payments were executed by the Bundesbank and Bank of Japan to the

Federal Reserve. Also, payments to the World bank or the United Nations are executed
through central banks.
Intervention in the United States foreign exchange markets by the U.S.
Treasury and the Federal Reserve is geared toward restoring orderly conditions
in the market or influencing the exchange rates. It is not geared toward
affecting the reserves.
There are two types of foreign exchange interventions: naked intervention
and sterilized intervention.
Naked intervention, or unsterilized intervention, refers to the sole foreign
exchange activity. All that takes place is the intervention itself, in which the

Federal Reserve either buys or sells U.S. dollars against a foreign currency. In
addition to the impact on the foreign exchange market, there is also a monetary
effect on the money supply. If the money supply is impacted, then consequent
adjustments must be made in interest rates, in prices, and at all levels of the
economy. Therefore, a naked foreign exchange intervention has a long-term
Sterilized intervention neutralizes its impact on the money supply. As there
are rather few central banks that want the impact of their intervention in the
foreign exchange markets to affect all corners of their economy, sterilized
interventions have been the tool of choice. This holds true for the Federal
Reserve as well.
The sterilized intervention involves an additional step to the original
currency transaction. This step consists of a sale of government securities that
offsets the reserve addition that occurs due to the intervention. It may be easier
to visualize it if you think that the central bank will finance the sale of a currency
through the sale of a number of government securities.
Because a sterilized intervention only generates an impact on the supply
and demand of a certain currency, its impact will tend to have a short-to
medium-term effect.
The Central Banks of the Other G-7 Countries
In the wake of World War II, both Germany and Japan were helped to
develop new financial systems. Both countries created central banks that were
fundamentally similar to the Federal Reserve. Along the line, their scope was
customized to their domestic needs and they diverged from their model.
The European Central Bank was set up on June 1, 1998 to oversee

ascent of the euro. During the transition to the third stage of economic and
monetary union (introduction of the single currency on January 1, 1999), it was
responsible for carrying out the Community's monetary policy. The ECB, which
is an independent entity, supervises the activity of individual member European
central banks, such as Deutsche Bundesbank, Banque de France, and Ufficio
Italiano dei Cambi. The ECB's decision-making bodies run a European System of
Central Banks whose task is to manage the money in circulation, conduct
foreign exchange operations, hold and manage the Member States' official foreign
reserves, and promote the smooth operation of payment systems. The ECB is
the successor to the European Monetary Institute (EMI).
The German central bank, widely known as the Bundesbank, was the
model for the ECB. The Bundesbank was a very independent entity, dedicated to
a stable currency, low inflation, and a controlled money supply. The
hyperinflation that developed in Germany after World War I created a fertile
economic and political scenario for the rise of an extremist political party and for

the start of World War II. The Bundesbank's chapter obligated it to avoid any such
economic chaos.
The Bank of Japan has deviated from the Federal Reserve model in terms
of independence. Although its Policy Board is still fully in charge of monetary
policy, changes are still subject to the approval of the Ministry of Finance
(MOF). The BOJ targets the M2 aggregate. On a quarterly basis, the BOJ
releases its Tankan economic survey. Tankan is the Japanese equivalent of the
American tan book, which presents the state of the economy. The Tankan's
findings are not automatic triggers of monetary policy changes. Generally, the
lack of independence of a central bank signals inflation. This is not the case in
Japan, and it is yet another example of how different fiscal or economic policies
can have opposite effects in separate environments.
The Bank of England may be characterized as a less independent central
bank, because the government may overrule its decision. The BOE has not had an
easy tenure. Despite the fact that British inflation was high through 1991, reaching
double-digit rates in the late 1980s, the Bank of England did a marvelous job of
proving to the world that it was able to maneuver the pound into mirroring the
Exchange Rate Mechanism.
After joining the ERM late in 1990, the BOE was instrumental in keeping
the pound within its 6 percent allowed range against the deutsche mark, but the
pound had a short stay in the Exchange Rate Mechanism. The divergence
between the artificially high interest rates linked to ERM commitments and
Britain's weak domestic economy triggered a massive sell-off of the pound in
September 1992.The Bank of France has joint responsibility, with the Ministry of Finance, to
conduct domestic monetary policy. Their main goals are non-inflationary growth
and external account equilibrium. France has become a major player in the
foreign exchange markets since the ravages of the ERM crisis of July 1993, when
the French franc fell victim to the foreign exchange markets.
The Bank of Italy is in charge of the monetary policy, financial
intermediaries, and foreign exchange. Like the other former European
Monetary System central banks, BOI's responsibilities shifted domestically
following the ERM crisis. Along with the Bundesbank and Bank of France, the Bank
of Italy is now part of the European System of Central Banks (ESCB).
The Bank of Canada is an independent central bank that has a tight rein on
its currency. Due to its complex economic relations with the United States, the
Canadian dollar has a strong connection to the U.S. dollar. The BOC intervenes
more frequently than the other G7 central banks to shore up the fluctuations of
its Canadian dollar. The central bank changed its intervention policy in 1999 after

admitting that its previous mechanical policy, of intervening in increments of
only $50 million at a set price based on the previous closing, was not working.

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