The decision of the five major industrial powers to take a more forceful approach to driving down the value of the dollar will make life more hectic at the New York Federal Reserve Bank.
Whenever the United States decides to "intervene" in foreign exchange markets -- whether to buy dollars to try to drive the value up ,or to sell them in order to drive the value down -- the intervention begins with a telephone call from the New York Fed to one or more of the roughly 40 big banks with which it does foreign currency business.
The tactics of the intervention can vary. The Fed may want the foreign currency markets to know it is buying or selling dollars. Or it may want the market to guess, or even to believe that the Federal Reserve is not "in the market."
More than $100 billion of foreign currency is bought and sold every day around the world -- nearly all of it by banks acting for customers or trading for their own accounts.
If the Fed wants the world to know what it is doing, it calls up a bank and directly places an order for, say, West German marks. The bank is under no obligation to keep the sale confidential. But if the Fed wants to intervene quietly, it hires a bank to be its "agent." In that case, the bank is required to keep its relationship confidential.
In the coming months, most of the interventions by the New York Fed will involve selling the dollar -- or more precisely, buying a foreign currency and paying for that currency in dollars. The theory behind such actions is that making dollars more widely available in international currency markets will drive down its value, just as an increase in the quantities of any commodity typically reduces its price.
Suppose the United States wants to drive down the value of the dollar in terms of West German marks and does not mind, perhaps even prefers, that the world foreign currency markets know it is buying.
The Fed would call a bank and tell the bank it wants to buy, say, $100 million worth of German marks. The Fed would pay for the marks by making a deposit in dollars in the bank's account at the Federal Reserve.
Once the bank received the dollar deposit -- usually two days later -- the bank would then tell the Fed it had $100 million of marks on deposit at a bank in West Germany and request instructions on what to do with the mark deposit. Generally the Fed tells the bank to transfer the marks to the account the Federal Reserve maintains at the West German central bank, the Bundesbank.
When the Fed sells dollars to drive down the currency's value, it increases the level of bank reserves in the United States. In the example above, it would add $100 million to a U.S. bank's reserves in exchange for mark deposits in Germany. That would increase the ability of the bank to make loans, which might increase money growth faster than the Fed wants. That, in turn, could have an impact on inflation.
To neutralize -- or sterilize in Fed parlance -- the impact of foreign currency purchases on the U.S. banking system, another arm of the Federal Reserve would would act to soak up reserve from domestic banks. It would do so by selling an equivalent amount of U.S. Treasury securities on the open market.
The purchasers of the securities would have to draw down their bank accounts to pay for the bills, offsetting the injection of cash that occurred because of the Fed purchase.
When the Fed transfers its marks from a West German bank account to the Bundesbank, bank reserves in West Germany would decline by $100 million. The Bundesbank would have to decide whether to add marks to the German banking system or permit bank reserves -- and therefore the ability of German banks to make loans -- to decline.