TREASURY AND FEDERAL RESERVE FOREIGN EXCHANGE OPERATIONS

October-December 1996

During the quarter, the dollar appreciated 3.9 percent against the yen and 0.9 percent against the mark, at one point establishing forty-five-month and twenty-four-month highs of ¥116.40 and DM 1.5665, respectively. On a trade-weighted basis against the currencies of the other G-10 countries, the dollar appreciated 0.2 percent. The dollar strengthened despite a shift in market expectations during the quarter from anticipation of a near-term tightening of U.S. monetary policy to the view that the Federal Open Market Committee (FOMC) would not take any action through the end of the year. Against the yen, the dollar was supported by perceptions of substantial Japanese capital outflows, as economic data and concerns about the Japanese financial system reaffirmed expectations that Japanese monetary policy would remain unchanged. After trading slightly weaker against the mark early in the period, the dollar appreciated against the German currency following calls from several European officials welcoming further depreciation of their currencies. Also, general optimism about the European Monetary Union (EMU) process prompted flows out of marks into other European currencies. The U.S. monetary authorities did not undertake any intervention operations during the quarter.

EXCHANGE RATES REMAIN GENERALLY STABLE DURING THE QUARTER
The relative stability that characterized foreign exchange markets through the first three quarters of 1996 continued during the period. Although the average daily trading range for the dollar increased slightly from the previous quarter, it remained substantially less than the range observed for the same period in 1995. On average, the dollar traded in a daily range of 0.7 percent against both the mark and the yen. This compares with daily ranges of 0.6 percent against both currencies in the previous period, and with 1.0 percent against the mark and 1.1 percent against the yen for the fourth quarter of 1995.

Despite a few brief periods of sharp movements, the dollar generally firmed in a moderate manner throughout the period.

Nevertheless, implied volatility on dollar mark and dollar yen one-month options increased during the quarter. The probability distribution of future exchange rates implied by currency options prices became notably wider, possibly reflecting some concern about the variability of the future spot rate.

EXPECTATIONS FOR U.S. MONETARY POLICY SHIFT TO NEUTRAL
The decision of the FOMC to leave rates unchanged in September, followed by evidence of an economic slowdown and benign inflationary pressures, shifted expectations for U.S. monetary policy from near-certain tightening in late 1996 to a widespread consensus that the Committee would not take any action by year-end. At certain points during the quarter, the weaker data even spawned tentative discussions of the prospect of easing. Despite the shift in market expectations, and the corresponding downward trend in U.S. forward rates, the dollar appreciated during the period as non-U.S. factors appeared to dominate currency trading.

THE YEN DEPRECIATES AMID PERCEPTIONS OF JAPANESE CAPITAL OUTFLOWS
Japanese economic data, as well as the failure of several financial institutions, suggested that the pace of economic recovery in Japan had not accelerated, and bolstered market expectations that a near-term tightening of Japanese monetary policy was unlikely. The anticipation of fiscal contraction in 1997 and weakness in the Nikkei stock index helped solidify this view.

The yen weakened substantially in this environment not only against the dollar but also on a trade-weighted basis as ongoing reports of capital outflows from Japanese investors seeking higher yields overseas pressured the currency. In October and November, net capital outflows from Japan exceeded 1 trillion yen each month. Reportedly contributing to the capital outflow was the reallocation of additional funds from domestic to international portfolios with the start of the Japanese fiscal half-year on October 1.

As the yen continued to weaken, market participants began to speculate about the degree of official tolerance for additional depreciation of the Japanese currency. On November 7, comments by Japanese officials suggested that Japanese economic weakness was overstated and that the yen was unlikely to weaken further. After having strengthened above ¥114 earlier in the quarter, the dollar retraced most of its prior gains following these comments, weakening almost 2 yen, the sharpest one-day move in the period. Although speculation about Japanese official views on the exchange rate dominated dollar yen trading for the remainder of the quarter, the yen continued to depreciate as market participants saw little tangible evidence of a Japanese economic recovery.

U.S. and Japanese trade data during the period suggested that the pace of adjustment in the Japanese external imbalance might be slowing and focused attention on the rising dollar as a potential trade issue. Nevertheless, trade data released during the period had little lasting impact on currency trading, and expectations of Japanese capital outflows dominated market psychology.

THE DOLLAR REACHES A NEW 1996 HIGH AGAINST THE MARK
Against the mark, the dollar weakened slightly early in the period amid open debates over the terms of the economic stability pact, which dampened optimism about the EMU process, and a growing belief that Germany had reached the end of its easing cycle. At the same time, ebbing expectations of an FOMC tightening prompted a narrowing of long-term interest rate differentials and reduced a key element of support for the dollar. Meanwhile, the mark was also supported by heavy flows out of yen.

The dollar began a rapid appreciation midway through the period, however. In nine consecutive trading sessions between November 21 and December 4, the dollar strengthened from just below DM 1.50 to over DM 1.56, with each closing rate exceeding that of the previous day. The dollar appreciation coincided with more favorable EMU sentiment following the Italian lira's re-entry to the European Exchange Rate Mechanism and indications that a stability pact would be negotiated at the Dublin summit. In addition, the dollar benefited from a brief reconsideration of prospects for further easing in Germany and the perception that the monetary authorities of Continental Europe would welcome further depreciation of their currencies.

In the first two weeks of December, equity, fixed income, and currency markets became more volatile as market participants closed out positions ahead of year-end. Nevertheless, previously established themes, particularly with respect to expectations for continued Japanese capital outflows, dominated holiday-thinned currency trading, and the dollar continued to appreciate at the approach of year-end.

TREASURY AND FEDERAL RESERVE FOREIGN EXCHANGE RESERVES
At the end of the quarter, the foreign currency reserve holdings of the Federal Reserve System and the Exchange Stabilization Fund (ESF) were valued at $19.2 billion and $15.6 billion, respectively, and consisted of German marks and Japanese yen.

The U.S. monetary authorities invest all their foreign currency balances in a variety of instruments that yield market-related rates of return and have a high degree of liquidity and credit quality. A significant portion of these balances is invested in German and Japanese government securities held either directly or under repurchase agreement. As of December 31, outright holdings of government securities by U.S. monetary authorities totaled $7.7 billion.

Japanese and German government securities held under repurchase agreement are arranged either through transactions executed directly in the market or through agreements with official institutions. Government securities held under repurchase agreements by the U.S. monetary authorities totaled $10.5 billion at the end of the quarter. Foreign currency reserves are also invested in deposits at the Bank for International Settlements and in facilities at other official institutions.