An Analysis of Recent Studies of the Effect of Foreign Exchange Intervention
Neely, Christopher J., Federal Reserve Bank of St. Louis Review
Two recent strands of research have contributed to our understanding of the effects of foreign exchange intervention: (i) the use of high-frequency data and (ii) the use of event studies to evaluate the effects of intervention. This article surveys recent empirical studies of the effect of foreign exchange intervention and analyzes the implicit assumptions and limitations of such work. After explicitly detailing such drawbacks, the paper suggests ways to better investigate the effects of intervention.
Foreign exchange intervention is the practice of monetary authorities buying and selling currency in the foreign exchange market to influence exchange rates. Researchers have studied whether intervention is successful in influencing exchange rate movements and how it affects volatility. Secondarily, they have asked how the type of intervention affects these results and through which channels it might operate.
Intervention has several characteristics that complicate one's ability to study it. It is conducted sporadically, with several interventions over the course of a few days or weeks. Thus, it has an unusual distribution. Intervention policy is rarely stable for long periods. Finally, because intervention quickly reacts to exchange rate movements and other variables, exchange rates and intervention are determined simultaneously. These problems have made it difficult to show that central bank intervention has reduced exchange rate volatility or moved the exchange rate in the desired direction. Yet, every central banker surveyed in Neely (2000)--those who actually conduct intervention--remains convinced that intervention is effective in changing the exchange rate. (1)
Recently two phenomena have advanced our understanding of intervention. The first is the use of event studies to evaluate the effects of intervention. Generically, an event study is an examination of asset price behavior associated with some event, such as a merger, announcement, or intervention. Event studies are used to assess the market's reaction to the event, how the event influenced prices, and whether the market priced the event efficiently. The second advance is the use of high-frequency data--both exchange rates and intervention--to better understand the behavior of exchange rates immediately around intervention.
Despite these advances, inferring the effects of central bank intervention remains difficult. Although describing the data is a worthy and necessary goal, explaining the nature of the process by which exchange rates and intervention are jointly determined requires strong assumptions, which are rarely explicitly stated. While many intervention researchers are doubtless cognizant of such issues, those less familiar with the literature are probably not well aware of them. The purpose of this article is to selectively review the recent literature on the effects of intervention and to analyze the assumptions and limitations of such exercises. (2) Identifying the assumptions and limitations of the intervention literature is not to condemn those procedures. Rather such recognition enables the limitations to be better understood and overcome. This paper does not expend much effort describing the disparate conclusions of the literature. The appendix summarizes such conclusions and specific methods for interested readers.
This article first discusses central bank intervention practices and explains how researchers typically study intervention. Selected intervention studies are then discussed. The fourth section considers the assumptions behind intervention studies, with a special emphasis on the often implicit assumptions behind the new event-study methodologies. In its conclusion, the article discusses the strengths and weaknesses of the methods of studying the effects of intervention and suggests avenues for future research.
CENTRAL BANK INTERVENTION
After the breakdown of the Bretton Woods system of fixed exchange rates in 1973, the Articles of the International Monetary Fund (IMF) were amended to provide that members "would collaborate with the Fund and other members to assure orderly exchange arrangements and to promote a stable system of exchange rates. …