Reserve Accumulation

Another unilateral approach to strengthening foreign currencies is to mimic the approach taken by some of our trading partners and accumulate foreign exchange reserves. By taking dollars and selling them in the market for other nations’ currencies, government can create additional demand for other currencies and increase their value. In terms of implementation, there are two meaningful avenues for doing so: the first is Treasury’s own assets, particularly its Exchange Stabilization Fund.

The President can direct the Treasury Secretary to use the ESF as he sees fit. However, the ESF is of limited size: its total net position is less than $40 billion, of which $10 billion is already invested in foreign currency instruments.22

The ESF can leverage itself,23 but at the risk of increasing the interest burden of the Federal government. Whatever foreign assets the ESF buys will of course yield something, but in the current global economy, its assets will almost certainly yield less than its liabilities, resulting in losses for taxpayers—as long as U.S. yields are in excess of our trading partners’, this is a negative carry proposition.

The Gold Reserve Act also authorizes24 the Secretary to sell gold in a way “the Secretary considers most advantageous to the public interest,” providing additional potential funds for building foreign exchange reserves. However, the Secretary is statutorily required to use the proceeds from such sales “for the sole purpose of reducing the national debt.”

This requirement can be reconciled with the goal of building foreign exchange reserves by having the ESF sell dollars forward.

If gold sales are used to deliver dollars into the forward contracts, it will likely satisfy the statutory requirement of reducing national debt. There are other means of structuring the ESF transaction as a form of debt contract to comply with the law. While this is probably statutorily permissible, selling national gold reserves to buy foreign exchange instruments could be politically costly, and changes the asset composition of the 22 https://home.treasury.gov/system/files/206/ESF-June-2024-FS-Trunc-Notes.pdf 23 USC 31 §5302(b) authorizes the Secretary to deal in “instruments of credit and securities the Secretary considers necessary.”

24 USC 31 §5116(a)(1)(A). A User’s Guide to Restructuring the Global Trading System 33 USG’s balance sheet. Still, because gold pays no interest, selling it for positive-yielding foreign debt should result in income for the U.S. Government.

The other means of building a reserve portfolio is to use the Federal Reserve’s System Open Market Account, since the Federal Open Market Committee authorizes the New York Fed to do so.25 Use of SOMA requires cooperation from the Fed—which, to repeat, is not impossible given the Fed defers to Treasury on currency policy, and can be the outcome of any number of agreements between the Fed and Treasury, but must be voluntary to preserve the Fed’s inflation fighting credibility.

Given the Fed’s ability to create money supply at will and operate with any capital position, size constraints do not arise from purchasing power, but rather from available assets to purchase. The greatest drawback of accumulating foreign exchange reserves is the need to buy something with those reserves— as always, exchange rates have two sides. If the Fed prints dollars to buy foreign currency, it must do something with that foreign currency. It can leave foreign currency at a foreign central bank, but that requires cooperation from that central bank and offers a relatively low yield. Since increasing money supply is inflationary, doing so imposes a cost on Americans, and using the proceeds to earn low levels of interest at a foreign central bank isn’t a productive use of funds.

Alternatively, a reserve fund can buy assets, like longer-term foreign government debt, or other assets, but that exposes taxpayers to credit or other forms of risk. If the Fed prints $1 trillion and uses it to buy European, Japanese and Chinese debt to support the major foreign currencies, that becomes $1 trillion at risk should a foreign government restructure its obligations, devalue its own currency, or experience some other form of crisis.

China has repudiated its debt in the past, and the Eurozone is a relatively new institution with kinks still being worked out. Just as America can use law like IEEPA to withhold remittances on UST securities owned by the foreign official sector, such policies can be levied by foreign governments against any American reserve portfolio; losses can be imposed on us by foreigners. A reserve portfolio can become a significant vulnerability. Moreover, even if we trusted assets from China to be money good, it’s not even clear what we could buy at scale given capital controls around the Chinese economy.

Just as with Treasury borrowing to buy foreign assets, the Fed will also likely lose money on a reserve portfolio. If the Fed’s purchase of foreign securities creates additional liabilities in the form of bank reserves and pays interest on those liabilities via the Interest on Reserve Balances, the trade will likely be negative carry for the Fed, as the interest on its assets is dominated by its funding costs. Such losses will impede the Fed’s ability to remit profits on its operating account to Treasury—assuming the Fed eventually returns to profitability. Taxpayers can suffer, as a result.

Moreover, this form of intervention can be more inflationary than some other types. When the dollars being sold are new dollars created by the central bank, money supply is expanding in a way that does not happen when foreign holders sell already-existing dollars, or if Treasury sells gold to buy foreign exchange. The inflationary impulse isn’t merely a weaker currency but a much more potent domestic liquidity provision too.

The Federal Reserve will doubtless seek to curtail this inflationary force, sterilizing some of the increase in money supply and curtailing its ability to weigh on the dollar. Sterilization will require tightening monetary policy by some other means—say, selling bills to offset the liquidity provision created by buying foreign exchange, or allowing longer-term SOMA holdings to mature off its balance sheet. If creating foreign exchange reserves through the central bank increases the money supply in a way the Fed deems inflationary, then to achieve its inflation priorities and all else equal, the central bank will at least partially offset such an increase by reducing money supply. That will support the dollar and counteract some of the effects of sales.

25 https://www.federalreserve.gov/monetarypolicy/files/FOMC_AuthorizationsContinuingDirectivesOMOs.pdf

The alternative to sterilization is to allow the inflation from additional liquidity provision to pass through the economy.

The need to sterilize central bank purchases of foreign exchange is what has led economists to believe this is not a fruitful means of intervening in the currency. It is possible that in the Basel endgame world with abundant reserves and interest on reserve balances, increases in base money will not lead to the same quantum of inflation that the Fed experienced in the past. Changes in the structure of the financial plumbing may mitigate the extent to which the Fed needs to sterilize increases in money supply, opting instead for adjustments to interest rates if any concerning inflation pressures materialize.

If the weak dollar policy is adopted in a time of quiescent inflation pressures, when an increase in the money supply is not a concern for monetary policymakers, then there is scope for reduced sterilization. Again, so much will depend on the economic environment in which such a policy is adopted.