Core Focus: The Federal Reserve’s passive management approach, the hierarchy of investment objectives (liquidity, safety, return), and the deliberate decision not to rebalance the currency composition in response to exchange rate movements.
In-Depth Notes:
The US approach to reserve management is characterized by a passive management philosophy. The foreign reserves portfolios are passively managed, with purchases and sales conducted to meet an asset allocation target; the target is determined based on the portfolio’s broader goals of maximizing return subject to the liquidity and safety objectives .
The Hierarchy of Investment Objectives:
The Federal Reserve’s investment framework is guided by a clear hierarchy of objectives :
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Liquidity: Liquidity is the primary investment objective of the foreign reserves portfolio. Foreign currency reserves are invested to ensure that adequate liquidity is maintained to meet potential needs.
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Safety: Maintaining a high degree of safety is essential, but is a secondary objective for the purposes of portfolio management.
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Return: Efforts to improve portfolio returns are considered only after the liquidity and safety objectives have been met.
The Passive Management Style:
The SOMA and ESF foreign currency reserves are managed so that their risk and return characteristics match as closely as possible . The manager of the SOMA and the ESF foreign reserves portfolios consults regularly with the FOMC and the U.S. Treasury regarding the disposition of investments and the status of the reserves portfolios .
The Decision Not to Rebalance:
A defining feature of US reserve management is the decision not to rebalance the currency composition in response to exchange rate movements. The US Treasury and Fed hold a certain number of euros and yen and, scant interest earnings aside, hold them from quarter to quarter . This means that the share of euro and yen in the US reserve portfolio drifts with the euro/yen exchange rate . The US authorities do not rebalance despite big swings in the euro/yen exchange rate .
The US practice of not rebalancing in response to changes in the euro/yen exchange rate allows changing exchange rates full play to alter shares; rebalancing them would offset euro/yen rate changes fully . This contrasts sharply with the management of very large reserves by other central banks, such as the Swiss National Bank, which has varying targets for the dollar .
Contrast with Other Reserve Managers:
The contrast between the management of the modest US reserves and the very large Swiss reserves in the face of exchange rate changes presents a stark contrast . The SNB’s large dollar purchases and its management of reserve composition are influenced by its desire to limit appreciation of the Swiss franc, reflecting different policy objectives .