In this paper, we describe the evolution of the Federal Reserve’s swap lines from their inception in 1962 as a mechanism to forestall claims on US gold reserves under Bretton Woods to their use during the Great Recession as a means of extending emergency dollar liquidity. We describe the Federal Reserve’s successes and failures. We argue that swaps calm crisis situations by both supplementing foreign countries’ dollar reserves and by signaling central-bank cooperation. We show how swaps exposed the Federal Reserve to conditionality and raised fears that they bypassed the Congressional appropriations process.
Foreign-exchange operations did not end after the United States stopped its activist approach to intervention. Japan persisted in such operations, but avoided overt conflict with its monetary policy. With the onset of the Great Recession, Switzerland has transacted in foreign exchange both for monetary and exchange-rate purposes, and key central banks have used swap facilities to extended their lender-of-last-resort functions. Developing and emerging-market economies continue to intervene, but their actions may hamper the development of their own foreign-exchange markets. China’s undervalued exchange rate is producing inflation and real appreciation, despite China’s efforts to sterilize its reserve accumulation.
The United States all but abandoned its foreign-exchange-market intervention operations in late 1995, when they proved corrosive to the credibility of the Federal Reserve's commitment to price stability. We view this decision as the culmination of the evolution of U.S. monetary policy over the past century from a gold standard to a fiat money regime. The abandonment of intervention was necessary to secure monetary policy credibility.
If official interventions convey private information useful for price discovery in foreign-exchange markets, then they should have value as a forecast of near-term exchange-rate movements. Using a set of standard criteria, we show that approximately 60 percent of all U.S. foreign-exchange interventions between 1973 and 1995 were successful in this sense. This percentage, however, is no better than random. U.S. intervention sales and purchases of foreign exchange were incapable of forecasting dollar appreciations or depreciations. U.S. interventions, however, were associated with more moderate dollar movements in a manner consistent with leaning against the wind, but only about 22 percent of all U.S. interventions conformed to this pattern. We also found that the larger the size of an intervention, the greater was its probability of success, although some interventions were inefficiently large. Other potential characteristics of intervention, notably coordination and secrecy, did not seem to influence our success rates.
Attitudes about foreign-exchange-market intervention in the United States evolved in tandem with views about monetary policy as policy makers grappled with the perennial problem of having more economic objectives than independent instruments with which to achieve them. This paper—the introductory chapter to our history of U.S. foreign exchange market intervention—explains this thesis and summarizes our conclusion: The Federal Reserve abandoned frequent foreign-exchange-market intervention because, rather than providing a solution to the instruments-versus-objectives problem, it interfered with the Federal Reserve’s ability to credibly commit to low and stable inflation. This chapter also provides a theoretical discussion of intervention, background on U.S. institutions for conducting intervention, and a roadmap to the remainder of our book.
By the early 1960s, outstanding U.S. dollar liabilities began to exceed the U.S. gold stock, suggesting that the United States could not completely maintain its pledge to convert dollars into gold at the official price. This raised uncertainty about the Bretton Woods parity grid, and speculation seemed to grow. In response, the Federal Reserve instituted a series of swap lines to provide central banks with cover for unwanted, but temporary accumulations of dollars and to provide foreign central banks with dollar funds to finance their own interventions. The Treasury also began intervening in the market. The operations often forestalled gold losses, but in so doing, delayed the need to solve Bretton Woods’ fundamental underlying problems. In addition, the institutional arrangements forged between the Federal Reserve and the U.S. Treasury raised important questions bearing on Federal Reserve independence.
The dollar’s depreciation during the early floating rate period, 1973–1981, was a symptom of the Great Inflation. In that environment, sterilized foreign exchange interventions were ineffective in halting the dollar’s decline, but they showed a limited ability to smooth dollar movements. Only after the Volcker FOMC changed its monetary-policy approach and demonstrated a willingness to maintain a disinflationary stance despite severe economic weakness and high unemployment did the dollar begin a sustained appreciation. Also contributing to the ineffectiveness of the interventions was the Desk’s method of operation. The small, covert interventions, particularly prior to 1977, seemed inconsistent with an expectations channel of influence, and financing intervention with short-term borrowed funds seemed inconsistent with a portfolio-balance channel of influence. The Desk never clearly articulated an intervention transmission mechanism. The episode indicated the shortcomings of sterilized intervention and led to their cessation in April 1981.
The Federal Reserve abandoned foreign-exchange-market intervention because it conflicted with the System’s commitment to price stability. By the early 1980s, economists generally concluded that, absent a portfolio-balance channel, sterilized foreign-exchange-market intervention did not provide central banks with a mechanism for systematically influencing exchange rates independent of their monetary policies. If intervention were to have anything other than a fleeting, hit-or-miss effect on exchange rates, monetary policy had to support it. Exchange rates, however, often responded to U.S. monetary-policy initiatives, so intervention to offset or reverse those exchange-rate responses can seem a contrary policy move and can create uncertainty about the strength of the System’s commitment to price stability. That the U.S. Treasury maintained primary responsibility for foreign-exchange intervention only compounded this uncertainty. In addition, many FOMC participants feared that swap drawings and warehousing could contravene the Congressional appropriations process and, therefore, potentially pose a threat to System independence, a necessary condition for monetary-policy credibility.
The deterioration in the U.S. balance of payments after 1957 and an accelerating loss of gold reserves prompted U.S. monetary authorities to undertake foreign-exchange-market interventions beginning in 1961. We discuss the events leading up to these interventions, the institutional arrangements developed for that purpose, and the controversies that ensued. Although these interventions forestalled a loss of U.S. gold reserves, in the end, they only delayed more fundamental adjustments and, in that respect, were a failure.