Central Bank Intervention and Foreign Exchange Volatility
Doroodian, K., Caporale, Tony, International Advances in Economic Research
TONY CAPORALE (*)
This paper provides additional empirical evidence on the topic of the effectiveness and the impact of Federal Reserve intervention on U.S. exchange rates. Using a daily measure of exchange rate intervention in the yen/dollar and mark/dollar exchange markets for the period January 3, 1985 to March 19, 1997, this paper finds a statistically significant impact of intervention on spot rates. A generalized auto-regressive conditional heteroskedasticity exchange rate equation is used to measure the impact of intervention on exchange rate uncertainty. This study finds that intervention is associated with a significant increase in the interday conditional variance (uncertainty) of both bilateral spot exchange rates. This supports the view of Friedman and Schwartz that exchange rate intervention serves to destabilize the foreign exchange market by introducing additional levels of exchange rate uncertainty. (JEL F31)
Of the many policies undertaken by the U.S. central bank, few have seemed to generate as much controversy as foreign exchange market intervention. Opponents argue that sterilized intervention has little lasting influence on exchange rates. Moreover, when the exchange rate market disturbance is neither domestic in origin nor monetary in nature, non-sterilized intervention conflicts with price stability.
Friedman  provides the classic argument against central bank intervention in foreign exchange markets. Later, the introduction of models that allowed for imperfect information [Brainard, 1967; Poole, 1970] led to the conclusion that exchange rate policies could be used for stabilization purposes. Boyer's  work on optimal foreign exchange market intervention helped to achieve an uneasy consensus in the theoretical literature. It was shown that optimal exchange rate policies lie between the theoretical extremes of complete exchange rate fixity and flexibility. Optimal policy responses were shown to be a function of the nature of the shocks to the economy as well as dependent on the degree of capital mobility in the economy.
In contrast, empirical work on the actual impact of foreign exchange intervention has not yielded a consensus framework or result. Studies that regressed the spot exchange rate on intervention variables have often found coefficients with ambiguous signs. (1) For example, one might interpret a negative coefficient as evidence that official sales of foreign exchange caused the dollar to depreciate (a perverse response) or that official sales prevented a steeper depreciation from occurring, a "leaning against the wind" response [Humpage, 1988; Dominguez and Frankel, 1993]. Friedman  suggests a simple way to determine the desirability of official intervention: test if intervention is profitable. Friedman claims that stabilizing intervention will make money on average since monetary authorities will sell (buy) currencies when they are on average above (below) their equilibrium values. Therefore, assessing the profitability of intervention can help determine whether such policies are on average stabilizing or destabilizing. Taylor  finds that official intervention is almost always unprofitable. These initial findings led to numerous studies on this topic, some of which find strong evidence of profitable intervention. (2) Most recently, Leahy  finds that official intervention by the Federal Reserve has consistently generated profits.
These conflicting results have led many researchers to adopt different empirical methodologies to study the impact of intervention. (3) However, these studies have done little to narrow the gap in opinion concerning intervention. Recent academic work concerning the appropriateness and effectiveness of official intervention range from Dominguez and Frankel's  generally favorable view to Schwartz'  contention that intervention is an "exercise in futility" that at best can have only a very short-run effect on exchange values and at worse serve to introduce harmful amounts of uncertainty and volatility in foreign exchange markets. …