Why Central Bank Intervention Can't Control Exchange Rates

Article excerpt

Why central bank intervention can't control exchange rates

Under the gold standard, currency exchange rates -- the price of one money in terms of another -- were constrained to a narrow band, and parities were fixed. Domestic monetary policy was essentially determined by gold flows: As gold flowed into a nation, that was a signal to increase monetary creation and set forces loose to encourage an adjustment in the balance of payments; conversely, gold outflows necessitated a tighter monetary policy.

The gold standard did not prevent recurring recessions and depressions, but so long as major countries stuck by the rule of the game and did not change parities, accelerating long-term inflation did not occur.

The major weakness of the system was the fact that domestic monetary policy was not free to address domestic woes. The major advantage was the flip side: The gold standard did exert discipline and prevented a long-term deterioration in the value of money.

The post-war Bretton Woods system, which lasted until 1973, was also a system of narrowly fixed exchange rates but with adjustable parities. It worked well for many years when capital flows around the world were highly restricted and in relatively small volume. But eventually it came apart as a result of U.S. inflation and the resulting destabilizing speculation against the dollar. When the dollar came under attack with a fixed exchange rate, it was certain the dollar would not be revalued. Speculators had little to lose and much to gain by betting against the dollar.

Since 1973 most of the world has been on a floating exchange rate system with respect to the dollar, albeit often a dirty float as monetary authorities attempted to influence exchange rates directly through intervention in exchange markets. It is important to recognize that the dollar exchange rate against other major currencies is determined in a massive and highly competitive market. Changes in the dollar exchange rate reflect a myriad set of changing demand and supply forces. Probably the most important is changing expectations concerning the supply of dollars vs. the supply of a foreign currency -- in other words, changing expectations concerning domestic monetary policy and inflation vs. foreign monetary policy and inflation. If the price rise in the United States is expected to exceed inflation abroad, then the dollar would almost certainly weaken.

But that is not all. Exchange rates are influenced by other factors, including tariffs and quotas at home and abroad, growth in productivity, relative tax rates and expectations concerning political stability. As these and other factors are changing constantly, the correct exchange rate today will not be the rate that clears the market tomorrow. Although the exact size of the dollar foreign exchange market is unknown, it is estimated that, on a heavy day, volume of transactions can exceed half a trillion dollars.

Because most exercises in coordinated intervention by major central banks around the world involve only several billion dollars over a period of a few days or weeks, the disparity between the size of the market and the size of cumulative intervention raises questions concerning the probability of success in affecting the equilibrium level of the dollar vs. other major currencies. But the problem is not quite that simple. There can be no doubt that dollar intervention accompanied by a change in monetary policy can indeed affect the dollar exchange rate. But so can a similar change in domestic monetary policy alone.

If the United States were to intervene in the foreign exchange market in an attempt to lower the value of the dollar, it would do so by instructing the Federal Reserve of New York to buy foreign currencies, usually the Deutsche mark or Japanese yen. Additions to Federal Reserve assets have the effect of increasing bank reserves and, hence, monetary creation unless offset in the domestic money market by selling an equal amount of Treasury securities. …