Changes in Foreign-Related Factors

The Federal Reserve has engaged in foreign currency operations for its own account since 1962. In addition, it acts as the agent for foreign currency transactions of the U.S. Treasury, and since the 1950s has executed transactions for customers such as foreign central banks. Perhaps the most publicized type of foreign currency transaction undertaken by the Federal Reserve is intervention in the foreign exchange markets. Intervention, however, is only one of several foreign-related transactions that have the potential for increasing or decreasing reserves of banks, thereby affecting money and credit growth.

Several foreign-related transactions and their effects on U.S. bank reserves are described in the next few pages. Included are some but not all of the types of transactions used. The key point to remember, however, is that the Federal Reserve routinely offsets any undesired change in U.S. bank reserves resulting from foreign-related transactions. As a result, such transactions do not affect money and credit growth in the United States.

Foreign Exchange Interventions for the Federal Reserve's Own Account

When the Federal Reserve intervenes in foreign exchange markets to sell dollars for its own account, it acquires foreign currency assets and reserves of U.S. banks initially rise. In contrast, when the Fed intervenes to buy dollars for its own account, it uses foreign currency assets to pay for the dollars purchased and reserves of U.S. banks initially fall.

Consider the example where the Federal Reserve intervenes in the foreign exchange markets to sell $100 of U.S. dollars for its own account. In this transaction, the Federal Reserve buys a foreign-currency-denominated deposit of a U.S. bank held at a foreign commercial bank and pays for this foreign currency deposit by crediting $100 to the U.S. bank's reserve account at the Fed. The Federal Reserve deposits the foreign currency proceeds in its account at a Foreign Central Bank, and as this transaction clears, the foreign bank's reserves at the Foreign Central Bank decline. See illustration 33 on pages 30-31. Initially then, the Fed's intervention sale of dollars in this example leads to an increase in Federal Reserve Bank assets denominated in foreign currencies and an increase in reserves of U.S. banks.

Suppose instead that the Federal Reserve intervenes in the foreign exchange markets to buy $100 of U.S. dollars, again for its own account. The Federal Reserve purchases a dollar-denominated deposit of a foreign bank held at a U.S. bank, and pays for this dollar deposit by drawing on its foreign currency deposit at a Foreign Central Bank. (The Federal Reserve might have to sell some of its foreign currency investments to build up its deposits at the Foreign Central Bank, but this would not affect U.S. bank reserves.) As the Federal Reserve's account at the Foreign Central Bank is charged, the foreign bank's reserves at the Foreign Central Bank increase. In turn, the dollar deposit of the foreign bank at the U.S. bank declines as the U.S. bank transfers ownership of those dollars to the Federal Reserve via a $100 charge to its reserve account at the Federal Reserve. See illustration 34 on pages 30-31. Initially, then, the Feds intervention purchase of dollars in this example leads to a decrease in Federal Reserve Bank assets denominated in foreign currencies and a decrease in reserves in U.S. banks.

As noted earlier, the Federal Reserve offsets or "sterilizes" any undesired change in U.S. bank reserves stemming from foreign exchange intervention sales or purchases of dollars. For example, Federal Reserve Bank assets denominated in foreign currencies rose dramatically in 1989, in part due to significant U.S. intervention sales of dollars. (See chart on this page.) Total reserves of U.S. banks, however, declines slightly in 1989 as open market operations were used to "sterilize" the initial intervention-induced increase in reserves.

Monthly Revaluation of Foreign Currency Assets

Another set of accounting transactions that affects Federal Reserve Bank assets denominated in foreign currencies is the monthly revaluation of such assets. Two business days prior to the end of the month, the Fed's foreign currency assets are increased if their market value has appreciated or decreased if their value has depreciated. The offsetting accounting entry on the Fed's balance sheet is to the "exchange translation account" included in "other F.R. liabilities." These changes in the Fed's balance sheet do not alter bank reserves directly. However, since the Federal Reserve turns over its net earnings to the Treasury each week, the revaluation affects the amount of the Fed's payment to the Treasury, which in turn influences the size of TT&L calls and bank reserves (See explanation on pages 18 and 19).

Page 29

Foreign-Related Transactions for the Treasury

U.S. intervention in foreign exchange markets by the Federal Reserve usually is divided between its own account and the Treasury's Exchange Stabilization Fund (ESF) account. The impact on U.S. bank reserves from the intervention transaction is the same for both - sales of dollars add the reserves while purchases of dollars drain reserves. See illustration 35 on pages 30-31. Depending upon the Treasury pays for, or finances, its part of the intervention, however, the Federal Reserve may not need to conduct offsetting open market operations.

The Treasury typically keeps only minimal balances in the ESF's account at the Federal Reserve. Therefore, the Treasury generally has to convert some ESF assets into dollar or foreign currency deposits in order to pay for its part of an intervention transaction. Likewise, the dollar or foreign currency deposits acquired by the ESF in the intervention typically are drawn down when the ESF invests the proceeds in earning assets.

For example, to finance an intervention sale of dollars (such as that shown in illustration 35), the Treasury might redeem some of the U.S. government securities issued to the ESF, resulting in a transfer of funds from the Treasury's (general account) balances at the Federal Reserve to the ESF's account at the Fed. (On the Federal Reserve's balance sheet the ESF'S account is included in the liability category "other deposits.") The Treasury, however, would need to replenish its Fed balances to desired levels, perhaps by increasing the size of TT&L calls - a transaction that drains U.S. bank reserves. The intervention and financing transactions essentially occur simultaneously. As a result, U.S. bank reserves added in the intervention sale of dollars are offset by the drain in U.S. bank reserves from the TT&L call. See illustration 35 and 36 on pages 30-31. Thus, no Federal Reserve offsetting actions would be needed if the Treasury financed the intervention sale of dollars through a TT&L call on banks.

Offsetting actions by the Federal Reserve would be needed, however, if the Treasury restored deposits affected by foreign-related transactions through a number of transactions involving the Federal Reserve. These include the Treasury's issuance of SDR or gold certificates to the Federal Reserve and the "warehousing" of foreign currencies by the Federal Reserve.

SDR certificates

Occasionally the Treasury acquires dollar deposits for the ESF's account by issuing certificates to the Federal Reserve against allocations of Special Drawing Rights (SDR's) received from the International Monetary Fund. For example, $3.5 billion of SDR certificates were issued in 1989, and another $1.5 billion in 1990. This "monetization" of SDR's is reflected on the Federal Reserve's balance sheet as an increase in its asset "SDR certificate account" and an increase in its liability "other deposits (ESF account)."

If the ESF uses these dollar deposits directly in an intervention sale of dollars, then the intervention-induced increase in U.S. bank reserves is not altered. See illustrations 35 and 37 on pages 30-31. If not needed immediately for an intervention transaction, the ESF might use the dollar deposits from issuance of SDR certificates to buy securities from the Treasury, resulting in a transfer of funds from the ESF's account at the Federal Reserve to the Treasury's account at the Fed. U.S. bank reserves would then increase as the Treasury spent the funds or transferred them to banks through a direct investment to TT&L note account.

Gold stock and gold certificates

Changes in the U.S. monetary gold stock used to be an important factor affecting bank reserves. However, the gold stock and gold certificates issued to the Federal Reserve in "monetizing" gold, have not changed significantly since the early 1970s. (See chart on this page.)

Prior to August 1971, the Treasury bought and sold gold for a fixed price in terms of U.S. dollars, mainly at the initiative of foreign central banks and governments. Gold purchases by the Treasury were added to the U.S. monetary gold stock, and paid for from its account at the Federal Reserve. As the sellers deposited the Treasury's checks in banks, reserves increased. To replenish its balance at the Fed, the Treasury issued gold certificates to the Federal Reserve and received a credit to its deposit balance.

Treasury sales of gold have the opposite effect. Buyers' checks are credited to the Treasury's account and reserves decline. Because the official U.S. gold stock is now fully "monetized," the Treasury currently has to use its deposits to retire gold certificates issued to the Federal Reserve whenever gold is sold. However, the value of gold certificates retired, as well as the net contraction in bank reserves, is based on the official gold price. Proceeds from a gold sale at the market price to meet demands of domestic buyers likely would be greater. The difference represents the Treasury's profit, which, when spent, restores deposits and bank reserves by a like amount.

While the Treasury no longer purchases gold and sales of gold have been limited, increases in the official price of gold have added to the value of the gold stock. (The official gold price was last raised from $38.00 to $42.22 per troy ounce, in 1973.

Warehousing


The Treasury sometimes acquires dollar deposits at the Federal Reserve by "warehousing" foreign currencies with the Fed. (For example, $7 billion of foreign currencies were warehoused in 1989.)

SDR's were created in 1970 for use by governments in official balance of payments transactions.