Is Foreign Exchange Intervention a Good Idea?
Humpage, Owen F., Shenk, Michael, Economic Trends
According to a recent article in the Financial Times, (1) 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 policy-makers 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. …