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Why Hasn't the United States Intervened?

The dollar's precipitous fall since February 2002, particularly against the euro, has renewed interest in foreign-exchange-market intervention, that is, official purchases and sales of foreign exchange designed to influence dollar exchange rates. Aside from a single transaction against the euro and a single transaction against the yen, the United States stopped intervening in 1995 for two very good reasons: First, foreign-exchange-market intervention has the potential to conflict with monetary policy and to create uncertainty about the ultimate objectives of monetary policy. Second, intervention has not been very successful.

Interventions: German Mark
Interventions: Japanese Yen

Technically, foreign-exchange interventions are very much like open-market operations, and like the latter, they can conceivably add or drain bank reserves. To stem a dollar depreciation, for example, the Federal Reserve Bank of New York might sell euros or Japanese yen to banks and debit their reserve accounts in payment. Such an intervention, if big enough, could indeed slow or reverse a dollar depreciation by reducing U.S. money growth. So why not intervene?

Because it isn't necessary. Or worse, such an intervention is likely to conflict with the domestic objectives of monetary policy. Intervention is unnecessary if the underlying cause of the dollar's depreciation is a rise in U.S. inflation. In that case, standard open-market operations can reduce the inflation rate and prop up the dollar. In all other cases, attempting to support the dollar through intervention sales of foreign exchange can conflict with the domestic objectives of monetary policy. When, for example, inflation expectations are fairly well contained and the FOMC is temporarily providing liquidity to stave off a credit collapse and the associate downside risks to real economic activity, selling foreign exchange to prop up the dollar will conflict with the domestic thrust of policy. The Federal Reserve does, of course, have a way around this problem. To avoid conflict with the domestic objectives of monetary policy, the Federal Reserve routinely offsets (or sterilizes) any intervention whose impact on bank reserves conflicts with the FOMC's federal-funds-rate target. In doing so, however, the Federal Reserve also prevents intervention from affecting key macroeconomic determinants of exchange rates - interest rates and money growth.

Sterilized intervention has long been a puzzle because economists are not quite sure how, or if, it works. According to the current best guess, central banks can sometimes convey information through sterilized intervention to foreign exchange traders that aids them in price discovery. Information is costly, and market participants do not continuously possess the same information about exchange rates. Large foreign-exchange traders may often have better information than their smaller counterparts because of broader customer bases and wider market networks. Such information asymmetries can sometimes encourage bandwagon effects, overreaction to news, and excessive volatility in uncertain exchange markets. If monetary authorities have better information about fundamentals than private traders, they may be able to impart this information to the market through their trades and improve the market's functioning. Central banks do have large information networks, and sometimes they have an inside track to impending policy changes.

Sounds grand, but do central banks, in fact, routinely have better information than foreign-exchange traders? If they do, then their interventions should be highly successful at influencing exchange rates.

Were U.S. Foreign Exchange Inverventions Successful?

Sample Period: March 2, 1973, to December 1998

Total Interventions Actual successes Expected successes Standard deviation
Was a U.S. purchase of German marks associated with
... dollar depreciation? 502 127 242 11
... a more moderate dollar depreciation? 502 96 64 7
... either of these criteria? 502 223 306 11
Was a U.S. purchase of Japanese yen associated with
... dollar depreciation? 150 47 48 5
... a more moderate dollar depreciation? 150 22 14 3
... either of these criteria? 150 69 62 5
Was a U.S. sale of German marks associated with
... dollar depreciation? 469 121 225 10
... a more moderate dollar depreciation? 469 90 59 7
... both of these criteria? 469 211 285 10
Was a U.S. sale of Japanese yen associated with
... dollar depreciation? 94 26 46 5
... a more moderate dollar depreciation? 94 23 12 3
... both of these criteria? 94 49 57 5

Between March 2, 1973, and December 31, 1998, the United States intervened in the foreign-exchange market on 652 days against German marks and on 563 days against Japanese yen. Most of these were purchases of foreign exchange. These interventions were not successful at producing a same-day dollar depreciation or appreciation; in fact, market participants generally could have profited by trading against U.S. monetary authorities. These interventions, however, were successful at moderating dollar appreciations or depreciations over the day of the intervention from the previous day. These successful interventions amounted to only about 20 percent of all transactions - so much for the routine information story.

The underwhelming success rate, however, was not the key reason that U.S. monetary authorities gave up on an active intervention program. As expressed at their October 3, 1989, meeting, the FOMC feared that even sterilized intervention ultimately must create uncertainty about the Federal Reserve's commitment to price stability. They determined that a central bank cannot credibly anchor inflation expectations and attempt to manage exchange rates.

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