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06.06.07

International Markets

Is Foreign Exchange Intervention a Good Idea?

According to a recent article in the Financial Times, U.S. Senate leaders are considering legislation to mandate that the U.S. Treasury intervene in foreign-exchange markets when currencies become fundamentally misaligned. Intervention refers to official purchases or sales of foreign currencies that are intended to influence exchange-rate behavior. To be sure, foreign-exchange intervention can sometimes temporarily affect exchange-rate movements, notably when markets are uncertain about evolving economic conditions and policy developments. Unfortunately, because foreign-exchange intervention never alters prices, interest rates, or other variables on the economic short-list of exchange-rate fundamentals, it does not provide policymakers with a means of determining longer-term exchange-rate movements. While monetary policy certainly could guide exchange rates, doing so would almost certainly conflict with domestic goals, notably price stability.

Except for the instruments involved, the mechanics of an intervention are exactly like those of an open-market operation, and like open-market operations, foreign-exchange interventions have the potential to alter the amount of reserves in the banking system. When the Federal Reserve Bank of New York buys foreign exchange either for the U.S. Treasury or for the Federal Reserve System's own portfolio, it pays for that foreign exchange by crediting the appropriate commercial banks' reserve accounts. Likewise, when it sells foreign exchange, it debits banks' reserve accounts. To avoid any conflict with the domestic objectives of monetary policy, central banks typically offset (or sterilize) the impact of any foreign-exchange intervention on bank reserves. In this way, they also prevent intervention from affecting a key macroeconomic determinant of exchange rates—money growth. Any central bank that conducts its monetary policy by targeting an overnight reserve-market interest rate, as the United States does, will automatically sterilize any operation that threatens its operating target.

Economists believe that sterilized intervention, which has no effect on money growth or other fundamental macroeconomic determinants of exchange rates, can nevertheless sometimes convey useful information about those fundamentals and improve price discovery in the foreign-exchange market. Because information is costly, market participants do not all continuously possess the same information about exchange rates. Large foreign-exchange dealers have better information than their smaller counterparts and other market participants because of their broader customer base and market networks. In markets with such information asymmetries, nonfundamental forces like bandwagon effects, overreaction to news, technical trading, and excessive volatility may sometimes underlie short-term exchange-rate dynamics. Any traders—including monetary authorities—who the market suspects of having superior information could conceivably improve the allocative efficiency of exchange rates, if market participants observed their trades.

If intervention is to systematically influence exchange rates, monetary authorities must routinely have better information about market fundamentals than private traders. Empirical studies do frequently find a connection between foreign-exchange intervention and day-to-day exchange-rate movements. Studies using data at an even higher frequency often find that exchange rates respond within minutes of an official operation. Large interventions, especially those undertaken with two or more central banks transacting in concert, are more likely to affect exchange rates in the desired direction than small, unilateral operations. Nevertheless, the empirical results are not robust across currencies, time periods, or empirical techniques, indicating that intervention is more of a hit-or-miss event than a sure bet.

Among the major developed countries, Japan is the only one to intervene with any frequency and force in recent years, and it is the current poster country for advocates of intervention. But, what exactly has Japan achieved through its operations?

On 307 days between May 13, 1991, and March 16, 2004, the Japanese Ministry of Finance bought approximately $577 billion, presumably to slow or to reverse a depreciation of the dollar relative to the yen. Of these many transactions, only 64 percent were associated with movements in the yen-dollar rate that an observer might reasonably associate with success. But given the day-to-day variation in the exchange rate, this success rate is exactly what chance predicts. Overall, then, the outcome was not very impressive.

Were Official Japanese Dollar Purchases Successful?

May 13, 1991, through March 16, 2004

  Total Actual
successes
Expected1
successes
Statistically
different?1,2
Associated with ...        
  a dollar appreciation
307
140
152
No
  a more moderate dollar depreciation
307
56
36
Yes
  either of these criteria
307
196
188
No

1. Assumes that successes are a hypergeometric random variable.
2. Tests whether actual successes are greater than expected success.

Yet if one squints a bit, more favorable results appear. The correspondence between official Japanese purchases of dollars and a moderation in the dollar’s rate of depreciation, for example, was much greater than chance could explain. Still, only 18 percent of the transactions fit this pattern. Also, over some individual subperiods, the success counts were substantially higher than over the entire period.

Even if you allow that interventions like these sometimes send exchange rates off along new paths, they do not necessarily change the ultimate outcome. Macroeconomic fundamentals seem to guide exchange rates over the long term, but over the short term, exchange rates demonstrate a curious zig-zag pattern as the market learns about evolving fundamentals and forms expectations about future developments. If a central bank intervenes, providing the market with new information pertinent to the pricing of foreign exchange but without changing the underlying macroeconomic fundamentals, the exchange rate will jump and begin moving along an alternative path. The new path, however, will be consistent with the fundamentals. In the end, despite the Japanese Ministry of Finance's $577 billion investment, the dollar depreciated 21 percent against the yen.


Economic Trends is published by the Research Department of the Federal Reserve Bank of Cleveland.

Views stated in Economic Trends are those of individuals in the Research Department and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. Materials may be reprinted provided that the source is credited.

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