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The Federal Reserve System of the USA and Central Banks of the Other G-7 Countries

Forek And Trading Strategy 1

The Federal Reserve System of the USA and Central Banks of the Other G-7 Countries – The Federal Reserve System of the USA Like the other central banks, the Federal Reserve of the USA affects the foreign exchange markets in three general areas:

  • the discount rate;
  • the money market instruments;
  • foreign exchange operations.

For the foreign exchange operations most significant are repurchase agreements to sell the same security back at the same price at a predetermined date in the future (usually within 15 days), and at a specific rate of interest.

The Federal Reserve System of the USA and Central Banks of the Other G-7 Countries

This arrangement amounts to a temporary injection of reserves into the banking system. The impact on the foreign exchange market is that the dollar should weaken. The repurchase agreements may be either customer repos or system repos.

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Matched sale-purchase agreements are just the opposite of repurchase agreements. When executing a matched sale-purchase agreement, the Fed sells a security for immediate delivery to a dealer or a foreign central bank, with the agreement to buy back the same security at the same price at a predetermined time in the future (generally within 7 days).

This arrangement amounts to a temporary drain of reserves. The impact on the foreign exchange market is that the dollar should strengthen. The major central banks are involved in foreign exchange operations in more ways than intervening in the open market.

Their operations include payments among central banks or to international agencies. In addition, the Federal Reserve has entered a series of currency swap arrangements with other central banks since 1962.

For instance, to help the allied war effort against Iraq’s invasion of Kuwait in 1990-1991, payments were executed by the Bundesbank and Bank of Japan to the Federal Reserve.

The Federal Reserve System of the USA and Central Banks of the Other G-7 Countries

Also, payments to the World bank or the United Nations are executed through central banks. Intervention in the United States foreign exchange markets by the U.S. Treasury and the Federal Reserve is geared toward restoring orderly conditions in the market or influencing the exchange rates. It is not geared toward affecting the reserves.

There are two types of foreign exchange interventions: naked intervention and sterilized intervention. Naked intervention, or unsterilized intervention, refers to the sole foreign exchange activity. All that takes place is the intervention itself, in which the Federal Reserve either buys or sells U.S. dollars against a foreign currency.

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In addition to the impact on the foreign exchange market, there is also a monetary effect on the money supply. If the money supply is impacted, then consequent adjustments must be made in interest rates, in prices, and at all levels of the economy. Therefore, a naked foreign exchange intervention has a long-term effect. Sterilized intervention neutralizes its impact on the money supply.

As there are rather few central banks that want the impact of their intervention in the foreign exchange markets to affect all corners of their economy, sterilized interventions have been the tool of choice. This holds true for the Federal Reserve as well. The sterilized intervention involves an additional step to the original currency transaction. This step consists of a sale of government securities that offsets the reserve addition that occurs due to the intervention.

It may be easier to visualize it if you think that the central bank will finance the sale of a currency through the sale of a number of government securities. Because a sterilized intervention only generates an impact on the supply and demand of a certain currency, its impact will tend to have a short-to medium-term effect.

The Federal Reserve System of the USA and Central Banks of the Other G-7 Countries

The Central Banks of the Other G-7 Countries In the wake of World War II, both Germany and Japan were helped to develop new financial systems. Both countries created central banks that were fundamentally similar to the Federal Reserve. Along the line, their scope was customized to their domestic needs and they diverged from their model.

The European Central Bank was set up on June 1, 1998 to oversee the ascent of the euro. During the transition to the third stage of economic and monetary union (introduction of the single currency on January 1, 1999), it was responsible for carrying out the Community’s monetary policy.

The ECB, which is an independent entity, supervises the activity of individual member European central banks, such as Deutsche Bundesbank, Banque de France, and Ufficio Italiano dei Cambi. The ECB’s decision-making bodies run a European System of Central Banks whose task is to manage the money in circulation, conduct foreign exchange operations, hold and manage the Member States’ official foreign reserves, and promote the smooth operation of payment systems.

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The ECB is the successor to the European Monetary Institute (EMI). The German central bank, widely known as the Bundesbank, was the model for the ECB. The Bundesbank was a very independent entity, dedicated to a stable currency, low inflation, and a controlled money supply. The hyperinflation that developed in Germany after World War I created a fertile economic and political scenario for the rise of an extremist political party and for the start of World War II. The Bundesbank’s chapter obligated it to avoid any such economic chaos.

The Bank of Japan has deviated from the Federal Reserve model in terms of independence. Although its Policy Board is still fully in charge of monetary policy, changes are still subject to the approval of the Ministry of Finance (MOF). The BOJ targets the M2 aggregate. On a quarterly basis, the BOJ releases its Tankan economic survey.

Tankan is the Japanese equivalent of the American tan book, which presents the state of the economy. The Tankan’s findings are not automatic triggers of monetary policy changes. Generally, the lack of independence of a central bank signals inflation. This is not the case in Japan, and it is yet another example of how different fiscal or economic policies can have opposite effects in separate environments. The Bank of England may be characterized as a less independent central bank, because the government may overrule its decision. The BOE has not had an easy tenure.

Despite the fact that British inflation was high through 1991, reaching double-digit rates in the late 1980s, the Bank of England did a marvelous job of proving to the world that it was able to maneuver the pound into mirroring the Exchange Rate Mechanism. After joining the ERM late in 1990, the BOE was instrumental in keeping the pound within its 6 percent allowed range against the deutsche mark, but the pound had a short stay in the Exchange Rate Mechanism.

The divergence between the artificially high interest rates linked to ERM commitments and Britain’s weak domestic economy triggered a massive sell-off of the pound in September 1992. The Bank of France has joint responsibility, with the Ministry of Finance, to conduct domestic monetary policy. Their main goals are non-inflationary growth and external account equilibrium.

The Federal Reserve System of the USA and Central Banks of the Other G-7 Countries

France has become a major player in the foreign exchange markets since the ravages of the ERM crisis of July 1993, when the French franc fell victim to the foreign exchange markets. The Bank of Italy is in charge of the monetary policy, financial intermediaries, and foreign exchange. Like the other former European Monetary System central banks, BOI’s responsibilities shifted domestically following the ERM crisis. Along with the Bundesbank and Bank of France, the Bank of Italy is now part of the European System of Central Banks (ESCB). The Bank of Canada is an independent central bank that has a tight rein on its currency.

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Due to its complex economic relations with the United States, the Canadian dollar has a strong connection to the U.S. dollar. The BOC intervenes more frequently than the other G7 central banks to shore up the fluctuations of its Canadian dollar. The central bank changed its intervention policy in 1999 after admitting that its previous mechanical policy, of intervening in increments of only $50 million at a set price based on the previous closing, was not working.

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