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February 24, 1978 Exchange Rates During 1977, the value of the dollar declined by 20 percent against the Japanese yen and the Swiss franc, and by 12 percent against the German mark and the British pound - with most of the decline concentrated in the fourth quarter of the year. The decline took place in the face of a massive intervention - perhaps $30 billion in all- by the central banks of Germany, Switzerland, Japan and Britain, as they bought dollars in order to curb the rise in values of their own currencies. The dollar stabilized early last month, following the Federal Reserve-Treasury announcement activating the Treasury's $41/2-billion Exchange Stabilization Fund and the Federal Reserve's $20-billion central-bank swap network in order to "check speculation and reestablish order in the foreign-exchange market. At present, it's uncertain whether this represents a temporary lull or a new equilibrium level for exchange markets. N Throughout the period of dollar decline, many foreign-trade experts attributed the phenomenon to a sharp increase in the nation's merchandisetrade deficit, from $9 billion in 1976 to $31 billion in 1977. However, the trade balance had been deteriorating steadily since early 1975 - yet the dollar actually appreciated (or remained stable) until the latter part of 1977 (see chart). If the deteriorating trade account has been the primary depressive factor affecting the dollar, why didn't the consequences appear at an earlier time? The trade deficit of course has had a part in exchange-market developments, but many monetary analysts point to another contributing factorthe relatively rapid pace of U.s.money expansion and the inflationary expectations it has engendered. The expansion began to show up in the closely-watched M1 measure last spring, somewhat later than it did in other monetary aggregates, and this fact may have influenced the timing of the exchange-rate decline. Inflatnon and the dollar Inflation and its related uncertainty affect dollar exchange rates in two distinct ways. When prices are rising faster in the u.s.than elsewhere, dollar exchange rates must depreciate at a rate about equal to the difference in inflation rates. With higher inflation, U.s. goods lose competitiveness, the trade accounts deteriorate, and eventually the dollar declines in the foreign-exchange market to reestablish competitiveness. In sum, ongoing inflation differences impart roughly equaland opposite - ongoing exchange-rate changes. This phenomenon affects all currencies in much the way. The second effect is more specific to the dollar as a major reserve asset. The dollar is used as a reserve asset because of its imputed stability and negotiability. Higher U.s.inflation and/or inflation uncertainty directly affect this stability, causing large shifts in asset preferences against the dollar. These "stock-demand adjustments affect N (continued on page 2) -------.----_ ..._----------------_. _-- exchange rates dramatically, and can cause short-run -dollar depreciation much larger than what inflation differentials alone would suggest. To summarize, when the growth rate of a reserve currency increases significantly, creating higher anticipated inflation, it can have immediate H ment effects on exchange rates as well as the ongoing effects of differences in long-run inflation rates. Over the last few years, financial markets have paid more attention to M 1 than the other aggregates. Because the mixed signal given by moderate M 1 growth and higher M2 growth in 1976 changed to a clear signal of high growth in both aggregates in mid1977, this shift may have been responsible for a shift in inflation expectations, impacting on exchange markets in mid- and late-1977. iE%oes§ To monetarist-minded observers, the delayed perception of greater U.s. inflation probably reflects the delayed acceleration of the closely watched M1 measure, in comparison with the earlier acceleration of the broader M2 and M3 measures. Up until about last April, technological and regulatory changes in the u.s. banking industry had caused shifts of funds from demand deposits (checking accounts) into time deposits (savings accounts). Because both are included in M2 and M3, their expansion rates were generally unaffected by these various changes. But because M 1 includes only currency and demand deposits, and excludes time deposits, the regulatory changes served to lower its growth rate below that of the other aggregates. These changes had roughly worked their way through the economy by early 1977, whence M1 started to show the faster growth reflected much earlier by M2 and M3. How substantial is this relatively faster rate of U.s. monetary expansion? The annual growth rate of M3 - defined as the narrow money supply (M1) plus near-monies - accelerated in the U.5. from 10.1 percent in the 1 972-75 period to 12.5 percent in the period between December 1975 and September 1977. In Germany, the growth rate decelerated from 9.2 percent to 7.6 percent between those two periods. In Japan and the U.K., money growth rates were much higher than the U.5. growth rate over the 1 972-75 period, but then they decelerated to at least slightly below the u.s. rate over the 1 976-77 periodspecifically, from 16.8 percent to 12.4 percent for Japan, and from 19.0 percent to 8.8 percent for the U.K. 2 The short-run consequence has been a more vigorous economic expansion in this country than in other industrial countries during the past several years. Over the longer run, however, another consequence could be a higher level of inflation in this country than elsewhere - or at least a greater expectation of long-run inflation. This situation then affects exchange rates in the ways already discussed. in the foreign exchange market. In the present instance, they argue that if the Federal Reserve's Foreign Desk uses intervention to decrease the supply of dollars held overseas to support its value, these actions might run counter to the expansive money-supply operations of the domestic Open-Market Desk. If the intervention involves swaps which only temporarily change the supply of domestic and foreign currencies, then the impact on exchange rates might be only temporary. And if foreign governments continue to intervene, thus selling their own currencies and buying dollars, they inevitably would choose higher rates of monetary expansion, further from their own targets, and closer to those of the According to the line of analysis sketched out here, a nation that desires to achieve higher short-term growth through monetary expansion may also have to accept the consequence of a depreciating dollar. In contrast, if a stable dollar is an overriding policy objective, a nation may also have to accept the implied constraints on shortrun domestic economic objectives. u.s. Keran and Mkhael Bazdarich Critics who follow this line also question the long-run value of intervention Percent Depreciation $ Millions 1600 , - - - - - - - - - - - - - - - - . 7 1200 S SOO 9 400 10 o 11 -400 12 -SOO 13 -1200 14 -1600 15 -2000 15 -2400 17 -2S00 is 1976 *Trade-weighted value, calculated 3 1977 from May 1970 base 4£ln 0 £!UJOJ!l£J • £P£A<3N .o4£PI £UOZ!JV £>jS£IV 0 !!£M£H 0 CG) 'me:) IOJSpueJ:IueS LSL 'O N OI'V'd :l9V1 S0d 's'n 1I1'V'W S5'V'l:) 1S<lI:I BANKING DATA-TWE LFTH FlEDlERAllRESlERVlE DISTRICT (Dollar amountsin millions) Selected Assets and liabilities large Commercial Banks Amount Outstanding Change from 2/8/78 2/1178 Loans(gross,adjusted)and investments* Loans(gross,adjusted)- total Securityloans Commercialand industrial Realestate Consumerinstalment U.s. Treasurysecurities Other securities Deposits(lesscash items)- total* Demand deposits(adjusted) U.s. Government deposits Time deposits- total* Statesand political subdivisions Savingsdeposits Other time depositsl LargenegotiableCD's 106,144 83,786 2,065 25,469 27,953 14,866 7,699 14,659 103,479 29,489 232 71,858 6,549 31,434 31,430 13,214 Weekly Averages of Daily Figu.res Week ended Week ended 2/8178 2/1178 106 161 55 46 26 72 + + 57 2 55 + 1,852 + 1,536 + 921 374 + 146 + + - + + - + + + - + - + + + 418 47 193 48 121 27 7 378 1,041 898 213 161 63 44 227 29 Changefrom year ago Dollar Percent + 13,819 + 13,519 721 + + 2,540 + 6,106 + 2,559 - 1,144 + 1,444 + 11,380 + 3,072 19 + 7,649 696 + 460 + + 6,030 + 4,174 14.97 19.24 53.65 11.08 + 27.95 + 20.79 12.94 + 10.93 + 12.36 + 11.63 - 7.57 + 11.91 + 11.89 1.49 + + 23.74 + 46.17 + + .+ + - Comparable year-agoperiod Member Bank Reserve Position ExcessReserves(+)/Deficiency(-) Borrowings Net free(+)/Net borrowed (-) + Federal Funds-Seven Large Banks Interbank Federalfund transactions Net purchases(+)/Net sales(-) Transactionswith U.s. security dealers Net loans(+)/Net borrowings (-) + 291 + *Includesitems not shown separately.llndividuals, partnershipsand corporations. Editorial comments may be addressed to the editor (William Burke) or to the author .. .• Information on this and other pUblications can be obtained by calling or writing the Public Information Section, Federal Reserve Bank of SanFrancisco, P.? Box 7702, San Francisco 94120. Phone (415) 544-2184.
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