Warehousing: A Historical Lesson in Central-Bank Independence

Federal Reserve warehousing--where the Fed and the US Treasury swap foreign-currency holdings--was one of the most controversial aspects of US foreign-exchange operations in the late twentieth century and a key factor in their termination. In the mid-1990s, as the Federal Open Market Committee (FOMC) worried about its reputation for price stability, warehousing reached its apogee. Many FOMC participants then feared that the operations jeopardized the Fed's independence--vital for policy credibility--because the transactions resembled a loan from the Fed to the Treasury, undertaken at the latter's behest and outside of the congressional appropriations process. Although the Fed has carried out no warehousing operations since 1992, the FOMC routinely renews the authorization (FOMC 2017, 5-7) that would allow such operations to resume. This Economic Commentary explains how a seemingly innocuous institutional arrangement, one designed to assist the Treasury, came to threaten the Fed's independence. (1)

Warehousing: How It Works and Why It Matters

In a typical warehousing operation, the Treasury's Exchange Stabilization Fund (ESF) sells foreign currency to the Fed and simultaneously repurchases it for delivery at a specific future date, generally within one year. (2) The Fed pays for the foreign exchange by crediting an ESF account with newly created dollar reserves, which the Fed then extinguishes when the swap reverses. Because both the spot and forward legs of the transaction are done at the same exchange rate, neither party incurs foreign-exchange risk from warehousing. The Fed places the warehoused foreign exchange in an interest-earning asset for the term of the swap and sterilizes (offsets) any unwanted changes in bank reserves that result from the ESF's use or repayment of the dollar funds. The Fed has no legal obligation to comply with a Treasury request to warehouse foreign exchange; it does so in a spirit of collegiality. The Treasury, for its part, can use the dollar proceeds in any manner that it chooses--not solely for foreign-exchange operations--by having the ESF invest the dollars in US Treasury securities, whose proceeds finance general expenditures.

Much of the controversy surrounding warehousing materialized because the swap resembled a loan to the US Treasury collateralized with foreign exchange. The Banking Act of 1935 prohibited the Federal Reserve from purchasing government obligations except in the open market, that is, the secondary market for government securities. Tire Fed was not to buy debt instruments directly from the Treasury. …

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