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August 1, 1992
eCONOMIG
COMMeNTORY
Federal Reserve Bank of Cleveland
Should the United States Hold
Foreign Currency Reserves?
by Gerald H. Anderson and Owen F. Humpage
A he United States holds a $43 billion
portfolio of foreign exchange reserves—
mostly German marks and Japanese yen —
to defend against unwanted depreciations
of the dollar in the world's currency markets. By selling these reserves when
demand for its currency weakens, the
United States can reduce the supply of
dollars and thereby resist a decline in the
dollar's foreign exchange price.
Although this approach can sometimes
be effective, we argue that, for the United
States, it is unnecessary. This country—
indeed, any nation with a well-developed
money market—need not sell foreign
exchange to reduce the supply of its currency; open-market sales of Treasury
securities can accomplish the same end.
Moreover, whereas many observers warn
of exchange risk, we contend that the
most important costs of holding a substantial foreign exchange portfolio and of
intervening in the foreign exchange markets are the uncertainty about monetary
policy priorities and the possible conflict
with price stability that can develop. The
enhanced ability to set an independent
monetary policy focused on domestic
price stability is, after all, the main reason
for adopting flexible exchange rates.
• Official International Reserves
All countries hold official portfolios of
international reserve assets to meet
temporary exchange-rate, or balance-ofpayments, problems. As in many countries, U.S. official international reserves
consist mainly of foreign exchange
holdings. Although we typically think
ISSN 0428-1276
of foreign exchange as foreign currencies,
the term more accurately refers to liquid
claims on foreign governments that earn
near-market rates of return. In addition to
its foreign exchange reserves, the United
States also holds official reserves in the
form of gold, Special Drawing Rights,
and a reserve position in the International
Monetary Fund (IMF).
Besides using official international reserves, most countries can also finance
a defense of their exchange rates by
borrowing foreign currency. The
United States, for example, maintains
an extensive set of short-term credit
lines ("swap" facilities) with many nations primarily for this purpose, and we
have also occasionally sold foreigncurrency-denominated bonds to acquire
ammunition for intervention.
Of all the types of international liquidity—official international reserves or
borrowing facilities—central banks
tend to favor foreign exchange reserves.
These are available virtually instantaneously, do not require government-togovernment consultation, and, unlike
borrowing, run no risk that the lender
will demand some type of macroeconomic policy concession to draw on
the credit line.
In part reflecting these considerations,
the United States began acquiring foreign exchange in the early 1980s (see
figure 1). Prior to 1978, we held only a
small amount—typically much less
than $1 billion—with gold making up
The United States, like most other
industrial nations, holds a large portfolio of foreign exchange reserves,
which we acquired over the last 10
years through intervention in the
world's currency markets. This Economic Commentary contends that for
countries with well-developed money
markets and flexible exchange rates,
holding vast amounts of foreign currency offers few advantages.
FIGURE 1
U.S. FOREIGN CURRENCY RESERVES
Billions of dollars
ou
50 40 30 /
20 10
0
/
^
•
•
•
I
.
I
.
I
1974 1976 1978 1980 1982 1984 1986 1988 1990 1992
NOTE: Data are year-end figures through 1991. Dot represents May 1992.
SOURCE: International Monetary Fund, International Financial Statistics, various issues.
the lion's share of our official international reserves. The extraordinary
growth in U.S. foreign exchange holdings occurred in 1988 and 1989 as a
result of attempts to prevent the dollar
from appreciating further against the
mark and yen. By 1990, our official
international reserves were valued at
about $83 billion. Of this amount, $52
billion, or approximately 60 percent,
was foreign currency.
In an effort to adjust these holdings, the
Federal Reserve undertook a series of
off-market transactions with foreign
monetary authorities last year. As a
result, U.S. foreign exchange reserves
have fallen to $43 billion.
• International Reserves,
Central Banks, and Money
Official international reserves are assets
on a central bank's balance sheet and
thus are a source of a nation's monetary base (see box 1). When a central
bank acquires foreign exchange through
intervention, it does so by trading its
own currency, thereby expanding the
nation's money supply. As a method for
influencing the domestic money supply,
exchange-market intervention differs
from open-market operations in government securities, or from lending operations with commercial banks, only in
the nature of the central bank assets
involved. A central bank can increase
its monetary base either by acquiring
international reserve assets (including
foreign exchange), by purchasing government securities, or by lending reserves to domestic commercial banks.
In most industrialized countries, however, central banks attempt to prevent
their foreign-exchange-market interventions, which are motivated by exchangerate objectives, from affecting their
domestic monetary policies, which are
motivated by inflation or business
cycle objectives. They do this by sterilizing their intervention with an offsetting transaction in some other asset.
Suppose, for example, that in an attempt to defend the mark-dollar exchange rate, the Federal Reserve System buys $100 million equivalent of
German marks from commercial
banks, thereby expanding the U.S.
monetary base by the same amount. If
this transaction were inconsistent with
its domestic objectives, the System
could simultaneously sell $100 million
in U.S. Treasury bills to commercial
banks, thereby reversing, or sterilizing,
the previous monetary expansion. The
Fed sterilizes all U.S. exchange-market
intervention, in the sense of not allowing intervention to interfere with its
monetary policy objectives.
• Money, Exchange Rates,
and Intervention
Nearly all economists agree that when
central banks allow intervention to alter
their relative money supplies, exchange
rates (which, after all, are simply the relative prices of currencies) change. Many,
however, question whether sterilized intervention can have lasting—or even predictable—influences on exchange rates.8
Empirical investigations show that sterilized intervention does not provide central
banks with a means for determining the
long-run path of their exchange rates.
Some studies, however, suggest two
ways in which such intervention could
have transitory effects. First, it might signal future, unanticipated monetary
policies to a basically efficient market.
Because such a market will discount
routine or otherwise predictable changes
in policy, the scope for constructive use
of sterilized intervention is narrow. Moreover, since a central bank must ultimately
accommodate such signals if the market
is ever to believe them, intervention of
this type cannot remain sterilized. Second,
in a market that is temporarily operating
on news unrelated to economic fundamentals or that is caught up in a speculative flurry, intervention might shake the
exchange rate back to a more sustainable
path. But to be successful, traders at the
central bank must have better information about market trends and fundamentals than do traders at commercial banks
—an improbable scenario.
The important point about sterilized intervention is that it most likely operates by
conveying information and by altering
market expectations—if it accomplishes
anything at all. It does this by signaling
to the market, not by changing market
fundamentals, so its influence is transitory. Consequently, many economists
question the need for holding a large portfolio of foreign currencies to finance
sterilized intervention.
BOX 1
MONETARY AUTHORITY'S BALANCE SHEET
Assets
Foreign Assets
Gold
Foreign exchange
Special Drawing Rights
Reserve position in IMF
Domestic Assets
Government securities
Loans to depository institutions
Other
• Why Other Countries
Hold Reserves
The foregoing arguments notwithstanding, most countries do in fact hold substantial amounts of foreign currency
reserves in anticipation of using them to
influence exchange rates. There are two
interrelated reasons for this, neither
of which pertains to the United States.
With the notable exceptions of this nation and Japan, nearly all major industrial countries limit movements in their
exchange rates. Countries that have
closely integrated goods and labor markets, that experience similar economic
disturbances, and that have comparable
inflation preferences often find that
adopting fixed or relatively inflexible
exchange rates between their currencies
is more conducive to their economic
growth and stability than accepting
market-determined rates.
For that reason, most western European
nations, including Germany, France,
Italy, and the United Kingdom, have
adopted a formal agreement that mandates intervention. Members of the European Exchange-Rate Mechanism (ERM)
agree to maintain their exchange rates
within narrow margins around a fixed but
adjustable central rate. Intervention within the margins is optional, but at a margin,
it is mandatory.
Liabilities
Monetary Base
Currency held by the public
Depository institutions' reserves
Other Liabilities
Net Worth
Many more countries limit the fluctuations in their currencies without a formal agreement to do so, usually by stabilizing their exchange rates with their
most important trading partners.9 Sweden and Finland, for example, stabilize
their currencies relative to a weightedaverage index of their exchange rates
with close trading partners. Austria and
Norway, although not in the ERM, stabilize their currencies relative to those of
member nations. Similarly, Canada seems
to limit, although more loosely, movements in its currency's value relative to
the U.S. dollar.
Although the desire to limit movements in exchange rates offers a motive
for holding foreign currency reserves,
reserves are not necessarily needed for
that purpose. Countries that benefit
from holding substantial foreign exchange portfolios lack other means of
adjusting their monetary supplies quickly and frequently to the ebbs and flows
in the demand for their currencies.
They do not have broad, well-developed
money markets in which to conduct
open-market-type operations, and their
traditional instruments of monetary
policy are too inflexible to serve the
task. Buying and selling foreign currencies affords these nations a flexible
means of adjusting their money stocks
in a manner sufficient to stabilize exchange rates.
Central banks in most large industrial
countries have traditionally implemented
their monetary policies by adjusting their
discount rates and discount-window
quotas with commercial banks, or by
rationing bank credit to the general public. Although these instruments can be
highly effective, they do not accommodate frequent or marginal adjustments, as
do open-market operations—the principal
means of implementing U.S. monetary
policy. Lacking broad and deep money
markets, many foreign central banks cannot engage in open-market-type policies
without a substantial risk of creating undesirable interest-rate volatility.
Although many countries lack welldeveloped domestic money markets, they
typically have much more extensive foreign exchange markets. Through foreign
exchange transactions, their central banks
can adjust their monetary bases to desired
levels as the need arises. In the late 1970s,
changes in foreign exchange reserves
accounted for nearly 70 percent of the
movements in Germany's monetary base,
and although the importance of such fluctuations for German monetary policy has
since declined, they still account for approximately 20 percent of the movements in this aggregate. This is the oftnoted sense in which holding foreign
exchange reserves provides central banks
with a greater degree of monetary
flexibility.11
For countries lacking access to a largescale domestic money market, holding
foreign currency reserves can be useful
for making quick, minor adjustments to
their monetary base. But the United States
neither manages dollar exchange rates nor
lacks well-developed money markets;
thus, we gain little from holding a large
portfolio of these reserves.
• The Costs of Holding
Foreign Exchange Reserves
Most discussions of the costs of holding foreign exchange reserves focus on
the potential for exchange-rate revaluation losses. The United States invests
its foreign exchange reserves in assets
that earn a near-market rate of return.
Hence, the overall profit or loss on our
foreign exchange position reflects two
components: investment returns, and
any valuation gains or losses.
Official data on profits or losses consider the interest earnings on our foreign exchange position, but to assess
the investment return properly, one
must also account for the opportunity
costs of holding foreign currency. The
return on a portfolio of short-term U.S.
Treasury securities could represent
these opportunity costs.
Valuation changes in our foreign exchange position stem from changes in
exchange rates. With most of our reserves held in German marks and Japanese yen, any depreciation of these
currencies relative to the dollar will result in valuation losses.
Exchange-market intervention can be
fully consistent with a monetary policy
designed to promote domestic price
stability, but only when the exchangemarket disturbance is domestic in origin and monetary in nature. During the
late 1970s, for example, the dollar depreciated sharply because of an overly
expansionary U.S. monetary policy.
The Federal Reserve intervened to
acquire dollars at the time, which was
fully consistent with the monetary
tightening required to reduce inflation.
The move was unnecessary, however,
since the System could have achieved
the same effect through open-market
operations. In fact, despite intervention
in the late 1970s, the dollar did not
begin to strengthen until after 1979,
when the Fed made credible changes to
tighten its policy stance.
Although profits and losses expand with
the amount of our foreign exchange holdings, focusing on a portfolio's return is
something of a red herring. If proper
account were taken of opportunity costs
and if currencies were invested at market
rates of return, one would expect that,
over time, interest parity would ensure
that the net investment results and any
valuation gains or losses would tend to
balance out. Indeed, the United States has
experienced periods of both losses and
profits on its portfolio.
When an exchange-market disturbance is
not domestic in origin and monetary in
nature, attempting to stabilize exchange
rates through intervention is incompatible
with price stability. If, for example, foreign demand for U.S. goods increases, intervention to stem the dollar's appreciation would tend to raise domestic prices.
Although such a move might stabilize the
exchange rate, it could destabilize the
domestic price index.
A more important cost of holding a large
amount of foreign exchange and of intervening is the possible interference with
domestic monetary policy objectives.
Although the United States has intervened from time to time since 1973, we,
unlike the ERM members and many
other countries, have refrained from
fixing dollar exchange rates precisely to
avoid this situation.
In addition to the immediate problem of
potential incompatibility with monetary policy, intervention can also raise
questions about future monetary priorities because it suggests that, under certain circumstances, the monetary
authority might arbitrarily depart from
price-level objectives. This could reduce the credibility of a central bank's
inflation stance, particularly in a country lacking a consistent track record for
price stability.
Similarly, holding a large portfolio of
foreign exchange reserves implies that a
central bank attaches a substantial probability to the prospects of a future currency
depreciation, and that it is willing to intervene heavily to offset that depreciation.
The implication is that the bank either
lacks faith in its own ability to avoid an
excessive monetary expansion, or that it
does not consider price stability to be its
primary policy objective.
• Conclusion
In 1973, when the present system of
flexible exchange rates began, many
economists expected the world's central banks to reduce their holdings of
foreign exchange reserves. This did not
happen, in part because of an unwillingness to give private-market forces totally free rein in determining exchange
rates, but more importantly, because
most countries lacked sufficient capacity for open-market-type operations. In
recent years, some nations have been
developing more-flexible monetary
policy instruments, which could eventually lead to reductions in their foreign
exchange holdings.
In these respects, the United States is exceptional, having both a well-developed
money market and a desire for monetary
independence. With but trifling exception, the Federal Reserve can influence
exchange rates only by altering U.S.
money growth, which requires only openmarket operations, not foreign exchange
operations. Moreover, the exceptional
cases in which sterilized intervention
might be effective do not require a huge
portfolio of foreign currency. In either
case, the costs of pursuing exchange-rate
policies can be a diminution of price
stability and of public confidence in the
Federal Reserve's assertions of a pricestability goal.
• Footnotes
1. All data are from the International Monetary Fund, International Financial Statistics, various issues. The latest publicly available data are for May 1992. All annual data
pertain to year-end amounts.
2. Special Drawing Rights are reserve assets
that the IMF issues to member countries for
use in official transactions. A member
nation's reserve position in the IMF is the
amount it can borrow without restriction.
3. Usually, this borrowing is government to
government, with the lender creating reserves
for the borrower. In late 1978 and in 1980,
however, the United States publicly issued
foreign currency bonds abroad.
4. In 1990, the remainder of our official
reserves consisted of $ 11 billion in Special
Drawing Rights, $ 11 billion in gold, and $9
billion in our reserve position with the IMF.
5. See "Treasury and Federal Reserve
Foreign Exchange Operations," Federal
Resen'e Bulletin, vol. 77, no. 10 (October
1991), pp. 784-788, especially p. 787.
6. Typically, a nation's fiscal authority—its
Treasury or Ministry of Finance—holds
some or all of its international reserves, and
the central bank's balance sheet contains a
corresponding entry. We treat all intervention
as solely central bank policy, a simplification
that does not affect our conclusions.
7. The Federal Open Market Committee
(FOMC), however, sometimes factors exchange rates into its deliberations, so that
U.S. monetary policy is not completely divorced from exchange-rate considerations.
See Dianne B. Pauls, "U.S. Exchange Rate
Policy: Bretton Woods to Present," Federal
Resen'e Bulletin, vol. 76, no. 11 (November
1990), pp. 891-908, especially p. 901.
8. See Owen F. Humpage, "Central-Bank
Intervention: Recent Literature, Continuing
Controversy," Federal Reserve Bank of
Cleveland, Economic Review, vol. 27, no. 2
(1991 Quarter 2), pp. 12-26.
9. This is particularly true of developing
countries.
10. See Manfred J.M. Neumann and J'urgen
von Hagan, "Monetary Policy in Germany,"
in Michele Fratianni and Dominick Salvatore,
eds., Handbook on Monetary Policy. Westport, Conn.: Greenwood Press, forthcoming
1992.
11. Since the early 1980s, Japan and most
large European countries have increasingly
conducted monetary policy through their
money and (more important) interbank markets, rather than through the traditional instruments mentioned above.
12. See Michael P. Leahy, "The Profitability
of U.S. Intervention," Board of Governors of
the Federal Reserve System, International
Finance Discussion Paper No. 343, February
1989.
Gerald H. Anderson and Owen F. Humpage
are economic advisors at the Federal Resen'e
Bank of Cleveland.
The views stated herein are those of the
authors and not necessarily those of the Federal Resen'e Bank of Cleveland or of the
Board of Governors of the Federal Resen'e
System.
1992:IIQ Economic Review Now Available
Economic Review is published quarterly by the Federal Reserve Bank of Cleveland. Below we present a summary of each of the
three articles contained in the most recent issue. Copies are available through the Public Affairs and Bank Relations Department,
1-800-543-3489.
Intervention and the Bid-Ask Spread
in G-3 Foreign Exchange Rates
by William P. Osterberg
An Ebbing Tide Lowers All Boats:
Monetary Policy, Inflation, and
Social Justice
Sluggish Deposit Rates: Endogenous
Institutions and Aggregate Fluctuations
by Joseph G. Haubrich
by David Altig
Recent research suggests that central
bank intervention may influence the volatility of foreign exchange rates or impair
the efficiency of such markets. Using official daily intervention data for Germany,
Japan, and the United States, the author
tests for whether the anticipation of intervention explains wider bid-ask spreads.
No evidence is found for such a relationship in the spot and forward rates of
marks/dollars and yen/ dollars. Rather, it
appears that narrower spreads are associated with periods of purported intervention and that spreads are narrower if,
conditional on the occurrence of intervention, the market is likely to have expected
intervention.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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Some economists argue that, because
low-income individuals are unduly burdened by unemployment and not much
affected by inflation in the short run,
fairness dictates expansionary monetary
policy in times of sluggish economic
activity. However, individuals with low
incomes are likely to be hurt in the long
run if such policies lead to higher inflation. This paper argues that the same social justice criterion that justifies the call
for the Fed to "do something" during
recessions supports the case for a longrun anchor to the price level.
This paper provides an equilibrium analysis of how endogenously arising financial
institutions alter the impact of macroeconomic shocks. It explains the low volatility
(sluggishness) of bank interest rates relative to other short-term rates and illustrates
a powerful principle: When aggregate disturbances also have distributional consequences, the shock can change the pattern
of prices specified by efficient contracts.
Interest-rate sluggishness arises because
banks provide insurance against individual
uncertainty, which itself is affected by economic conditions.
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