Central Bank

All central banks participate in their nations’ foreign exchange markets to some degree, and their operations can be of great importance to those markets. But central banks differ, not only in the extent of their participation, but also in the
manner and purposes of their involvement.

The role of the Federal Reserve in the foreign exchange market is discussed more fully in Chapter 9. Intervention operations designed to influence foreign exchange market conditions or the exchange rate represent a critically important aspect of central banks’ foreign exchange transactions. However, the intervention practices
of individual central banks differ greatly with respect to objectives, approaches, amounts, and tactics.

Unlike the days of the Bretton Woods par value system (before 1971), nations are now
free, within broad rules of the IMF, to choose the exchange rate regime they feel best suits their needs. The United States and many other developed and developing nations have chosen an “independently floating” regime, providing for a considerable degree of flexibility in their exchange rates. But a large number of countries continue to peg their currencies, either to the U.S. dollar or some other currency, or to a currency basket or a currency composite, or have chosen some other regime to limit or manage flexibility of the home currency.

The choice of exchange rate regime determines the basic framework within which each central bank carries out its intervention activities. The techniques employed by a central bank to maintain an exchange rate that is pegged or closely tied to another currency are straightforward and have limited room for maneuver or change. But for the United States and others with more flexible regimes, the approach to intervention can be varied in many ways—whether and when to intervene, in which currencies and geographic markets, in what amounts, aggressively or less so, openly or discreetly, and in concert with other central banks or not. The resolution of these and other issues depends on an assessment of market conditions and the objectives of the intervention.

As discussed in Chapter 9, the United States, operating under the same broad policy guideline over a number of years, has experienced both periods of relatively heavy intervention and periods of minimal activity. Foreign exchange market intervention is not the only reason central banks buy and sell foreign currencies.Many central banks serve as their government’s principal international banker, and handle most, and in some cases all, foreign exchange transactions for the government as well as for other public sector enterprises, such as the post office, electric power utilities, and nationalized airline or railroad.

Consequently, even without its own intervention operations, a central bank may be operating in the foreign exchange market in order to acquire or dispose of foreign currencies for some government procurement or investment purpose. A central bank also may seek to accumulate, reallocate among currencies, or reduce its foreign exchange reserve balances. It may be in the market as agent for another central bank, using that other central bank’s resources to assist it in influencing that nation’s exchange rate.

Alternatively, it might be assisting another central bank in acquiring foreign currencies needed for the other central bank’s activities or business expenditures.
Thus, for example, the Foreign Exchange Desk of the Federal Reserve Bank of New York engages in intervention operations only occasionally. But it usually is in the market every day, buying and selling foreign currencies, often in modest amounts, for its “customers” (i.e., other central banks, some U.S. agencies, and international
institutions).

This “customer”business provides a useful service to other central banks or agencies, while also enabling the Desk to stay in close touchwith the market for the currencies being traded.