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May 13, 1988

Divine Intervention?
The extent and speed of the depreciation of the
foreign exchange value of the dollar since the
bE@ririirig of 1985 surprised arid alarmed analysts, policymakers, and business leaders alike.
Reaching a peak in February 1985, the dollar's
fall initially was welcomed as the long-overdue
market adjustment of an over-valued currency.
But the dollar's continued slide aroused fears
that the currency was falling too far and too fast,
resulting in renewed inflationary pressures in the
U.5. and slower economic growth abroad. These
concerns led finance ministers and central
bankers at the Louvre meeting of the Group of
Seven (U.S., Germany, Japan, Italy, Britain,
France, and Canada) in February last year to
issue a communique calling for greater dollar
stability. The communique stated that currencies
were now "within ranges broadly consistent
with underlying fundamentals," and the governments agreed to stabilize the dollar both by
altering their macroeconomic policies and by
intervening in the foreign exchange markets to
prevent "excessive" volatility.
Since the Louvre G-7 meeting, central bank
intervention in foreign exchange markets has
been massive. Central banks abroad have purchased billions of dollars in foreign exchange
markets. West German international reserves
jumped more than 50 percent last year - growing to $79.3 billion from $51.7 billion during
1987. Japan's reserves jumped more than 90
percent in 1987, growing to $81.0 billion from
$42.3 billion. Italy, the United Kingdom, and
Canada had similar proportional gains.
This Letter reviews the theory of and recent
experience with foreign exchange market intervention and finds that intervention policy alone
cannot be relied upon to stabilize the value of
the dollar within a particular target zone unless
it also is supported by a shift in monetary policy
stance. Recent easing of monetary policies in
Japan and Germany may contribute to dollar stability if these policies are sl:lstained.
Monetary Intervention
To analyze the exchange rate impact of official
intervention in the foreign exchange market, it is

important to distinguish between "monetary," or
unsterilized, intervention operations and "nonmonetary," or sterilized, intervention operations.
In a monetary intervention aimed at supporting
the dollar, the Bank of Japan Uapan's central
bank), for example, typically buys dollars from a
Tokyo bank and credits the bank's reserve position in yen. The Tokyo bank ends up with fewer
dollars (its foreign currency asset) and greater
yen (home currency) reserves. Such intervention
by the Bank of Japan creates a position of excess
reserve holdings for the Japanese banking
With excess reserves, Japanese banks are in a
position to expand domestic (yen-based) lending. The greater availability of credit offered by
banks, in turn, tends to lower its price - Japanese interest rates - and raise the stock of
deposit money. Increased deposit money balances is the monetary component of intervention operations.
This monetary component of official intervention is likely to have powerful effects on
exchange rates. Lower relative interest rates in
Japan, for example, generate an outflow offunds
to U.5. capital markets as the yields on Japanese
securities fall relative to U.5. securities. As investors try to sell Japanese securities and buy dollars to acquire higher yielding U.S. securities,
upward pressure is placed on the dollar
exchange rate and it appreciates. Moreover, if
market participants believe that intervention
operations represent or "signal" the Japanese
central bank's willingness to sustain such easing,
the effect on exchange rates likely will be
Numerous empirical studies indicate strong
causal links running from monetary intervention
to exchange rates. This is not surprising. The
monetary effects (money supply changes and
interest rate movements) of such intervention
operations working through the foreign
exchange market are analogous to regular open
market monetary operations working through
the domestic bond market. Both change bank

reserve holdings in an analogous fashion. The
difference between the two is that in the intervention case, private banks' foreign asset holdings are changed, while in the case of open
market operations, banks' domestic bond holdings are changed. Hence, sustained monetary
intervention likely will have a powerful and
long-lasting effect on exchange rates primarily to
the extent that it represents a fundamental
change in the central bank's monetary policy
stance. That is, monetary intervention influences
the overall money growth rate, in addition to
shifting the apparatus of monetary control from
domestic open market operations to intervention
in the foreign exchange market.
Non-monetary Intervention
In the previous example, the Bank of Japan's
purchase of dollars in the Tokyo foreign
exchange market was allowed to increase the
Japanese money supply and lower Japanese
interest rates. The Bank of Japan, however,
could pursue non-monetary intervention byoffsetting or "sterilizing" this monetary effect
through the sale of a domestic (yen-denominated) security in open market operations. This
action reduces Japanese commercial bank yen
reserves to their initial level. The Japanese banking sector would have more domestic securities
in its portfolio, and fewer dollar-denominated
securities (those purchased by the Bank of

Japanese banks may have preferred the initial
mix of securities in their portfolios. If so, they
will try to restore their portfolios by buying dollar-denominated securities and selling yen
securities. This private shift toward dollar
securities at the expense of yen securities is
likely to induce capital outflow from Japan
towards the U .5., which, if quantitatively important, would place upward pressure on the dollar
exchange rate and cause it to appreciate.
These non-monetary or "sterilized" intervention
operations are likely to have much weaker
effects on exchange rates than their monetary
counterparts, however. Empirical research either
has failed to find any significant effects of sterilized intervention on exchange rates, or has
found that both its initjal magnitude and duration over time seem to vary from episode to

There are several reasons why the effects of sterilized intervention on exchange rates are likely
to be small, and to some extent unpredictable.
First, sterilized intervention, by definition, offsets
monetary effects and works only through
changes in interest rates associated with portfolio rebalancing. Second, investors may view
foreign and domestic securities as reasonably
close substitutes, at least on the margin. In our
example, if Japanese banks largely are indifferent between yen and dollar-denominated
securities on the margin, the Bank of Japan's
attempts to stabilize the dollar by buying dollar
securities for yen securities is likely to induce
only a small rebalancing effort and a small effect
on exchange rates and interest rates.
Third, investors' asset preferences between
domestic and foreign securities respond to a
variety offactors, including expectations regarding future policies, prospects for inflation, and
the overall investment climate. Thus, other factors besides central banks' sterilized intervention
operations also "upset" investors' portfolio balance, and may work against the intervention
operations. Most important in this regard are
bond financed government budget deficits,
which may introduce billions of dollars of new
security issues into private portfolios every year.
Deficit financing "upsets" portfolio balance, and
in turn, induces capital flows and exchange rate
effects on a scale typically much greater than
that associated with sterilized intervention
For these reasons, the effect of non-monetary, or
sterilized, central bank intervention on exchange
rates is difficult to detect empirically. Unlike the
effects of monetary intervention, both the initial
impact and the duration of non-monetary intervention seem to vary greatly in terms of magnitude and timing.
Recent Experience
On a day-to-day basis, the central banks of Germany and Japan generally attempt to sterilize
their intervention operations. In effect, however,
both West Germany and Japan have allowed a
large part of their dollar purchases in the foreign
exchange market to go unsterilized following the
Louvre agreement. As a consequence, both German and Japanese money growth has been rapid
over the past year. In Japan, the growth rate of

Chart 1
Trade-Weighted Exchange
Value of the Dollar

1973 = 100


Chart 2
G-7 Nation Foreign
Currency Reserves

Billions US $




Dec. 1987












broad money has accelerated almost continuously since thebeginning of last year, and for
the October-December quarter hit 11.8 percent
- the highest rate since the second quarter of
1979. The Bank of Japan is projecting even
higher growth this quarter. Similarly, money
growth in West Germany has overshot target
ranges for the second year in a row.
Supportingthese moves, both the Bank of Japan
and the Bundesbank lowered their central bank
discount rates by 50 basis points early last year.
Money market interest rates also declined in
both countries - rates in Japan declined from
4.18 percent in December 1986 to 3.2 percent
recently, while rates in Germany declined from
5.0 percent to 3.2 percent over the same period.
Monetary ease in Japan and Germany was not
pursued uniformly during the course of the year,
however. In the late summer, the Bank of Japan
and the Bundesbank made some attempt to slow
liquidity growth in response to a strengthening
dollar and concerns about the emergence of
inflationary expectations. The Bank of Japan
tried to moderate credit expansion by limiting
discount window borrowings and allowed shortterm interest rates to rise in the face of strong
money market conditions. The Bundesbank also
raised short-term interest rates. However, concern about the stability of the dollar and the
potential for financial market collapse that arose
in late October caused the two central banks to
abandon these attempts at restraint and continue
with more expansionary policies.





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But have these moves helped stabilize exchange
rates? The evidence suggests that monetary intervention has been moderately successful, while
the effects of non-monetary intervention have
been more difficult to detect. The dollar did not
stabilize immediately following the Louvre
agreement, despite large scale intervention operations that were allowed to have monetary
effects. Then, between May and August the dollar rallied sharply, appreciating almost four percent on a trade weighted (monthly average)
basis. However, when Germany and Japan tightened monetary policy through domestic operations, the dollar's gains quickly were reversed
and the dollar depreciated a further 11 percent
after August (See chart.) Si l1 ce the end of last
year, the dollar exchange rate has been somewhat more stable, but wasagain under downward pressure at the end of March and in midApril.
Thus, it appears that sustained monetary ease
abroad may be necessary to stabilize the
exchange value of the dollar. In this context, the
recent bouts of dollar weakness may be attributable to uncertainty in the market over the Japanese and German commitments to maintain
their present stances of monetary ease.

Michael Hutchison

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board ~f Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.


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The table entitled, "Selected Assets and Liabilities of Large Commercial Banks in the Twelfth
Federal Reserve District," will no longer be published in conjunction with the Weekly Letter.
For those in need of these data, a more timely publication entitled, "Weekly Consolidated
Condition Report of Large Commercial Banks and Domestic Subsidiaries" (F .R. 2416x), is
available from the Statistical and Data Services Department of this Bank.