Central bank intervention and exchange rate volatility


This paper explores the effects of foreign exchange intervention by central banks on the behavior of exchange rates. The G-3 central banks have undertaken an unprecedented number of both coordinated and unilateral intervention operations in the last 10 years. Existing empirical evidence on the effectiveness of intervention is mixed: studies using data from the 1970s suggest that intervention operations that do not affect the monetary base have, at most, a short-lived influence on exchange rates, but more recent studies indicate that the intervention operations that followed the Plaza Agreement influenced both the level and variance of exchange rates. This paper examines the effects of US, German and Japanese monetary and intervention policies on dollar-mark and dollar-yen exchange rate volatility over the 1977]1994 period. The results indicate that intervention operations generally increase exchange rate volatility. This is particularly true of secret interventions, which are those undertaken by central banks without notification of the public. Overt interventions in the mid-1980s appear to have reduced exchange rate volatility, but in other periods, and for the 1977]1994 period as a whole, central bank intervention is associated with greater exchange rate volatility. Q 1998 Elsevier Science Ltd. All rights reserved. JEL classification: F31 U Tel.: q1 734 7649498; fax: q1 734 7649498; e-mail: Kathryn y DominguezrFSrKSG@ksg.harvard.edu † I am grateful to seminar participants at Cornell, Georgetown, Harvard, Maastricht, McGill, NBER, MIT, NYU, Penn, and especially Susan Collins, Sylvester C.W. Eijffinger, Michael Klein, Jim Stock, and Shang-Jin Wei for helpful comments and suggestions on previous drafts. This research has been supported by NSF grant SBR-9311507 and the Olin Fellowship program at the NBER. 0261-5606r98r$19.00 Q 1998 Elsevier Science B.V. All rights reserved. Ž . P I I: S 0 2 6 1 5 6 0 6 9 7 0 0 0 5 5 7 ( ) K.M. Dominguez r Journal of International Money and Finance 17 1998 161]190 162 ‘‘The past has shown us that whenever the finance ministers from the Big Five get together there’s a lot of rhetoric and little action. Any time there’s talk of intervention and outside forces in the market, it creates volatility and uncertainty. But in the long term it doesn’t have any Ž . lasting impact... The Wall Street Journal, 9r23r85 .’’ Foreign exchange intervention operations are a controversial policy option for central banks. In one view, exemplified by the Wall Street Journal quote, intervention policy is not only ineffective in influencing the level of the exchange rate, but also dangerous, because it can increase the volatility of the rate. Others argue that intervention operations can influence the level of the exchange rate, and can also ‘calm disorderly markets’, thereby decreasing volatility. Yet others argue that intervention operations are inconsequential, since they neither affect the level nor the volatility of exchange rates. This paper explores the validity of these three disparate views by examining the effects of US, German and Japanese intervention operations on foreign exchange rate volatility over the period 1977 through 1994. During the period in which countries adhered to the Bretton Woods exchange rate system, intervention operations were required whenever rates exceeded their parity bands. After the breakdown of the system in 1973, intervention policy was left to the discretion of individual countries. It was not until 1977 that the IMF Executive Board provided its member countries three guiding principles for interŽ . vention policy: 1 countries should not manipulate exchange rates in order to prevent balance of payments adjustment or to gain unfair competitive advantage Ž . over others; 2 countries should intervene to counter disorderly market conditions; Ž . 2 and 3 countries should take into account the exchange rate interests of others. These principles implicitly assume that intervention policy can effectively influence exchange rates, and explicitly state that countries should use intervention policy to decrease foreign exchange rate volatility. After actively engaging in foreign exchange intervention in the 1970s, the United States abandoned intervention policy altogether during the period 1981 through 1984. In early 1985, after the dollar had appreciated by over 40% against the mark, and the US trade deficit was nearing $100 billion, the Federal Reserve System Ž . Fed in the United States joined with the Deutsche Bundesbank and the Bank of Ž . Japan BOJ to intervene against the dollar. In the autumn of 1985 the United States and the rest of the G-5 engaged in an unprecedented number of large and coordinated intervention operations as part of the Plaza Agreement. The G-5 1 Ž . Previous studies of the effects of intervention on the level of exchange rates include: Jurgenson 1983 ; Ž . Ž . Ž . Ž . Henderson and Sampson 1983 ; Loopesko 1984 ; Humpage 1989 ; Obstfeld 1990 ; Dominguez Ž . Ž . Ž . Ž . 1990a,b, 1992 ; Black 1992 ; Catte et al. 1992 ; Eijffinger and Gruijters 1992 ; Dominguez and Ž . Ž . Ž . Frankel 1993a,b,c ; Baillie and Osterberg 1997a and see the references in the Edison 1993 survey. Previous studies of the effect of intervention on the volatility of exchange rates include: Baillie and Ž . Ž . Ž . Ž . Humpage 1992 ; Dominguez 1993, 1997 ; Almekinders and Eijffinger 1994 ; Almekinders 1995 ; and Ž . Bonser-Neal and Tanner 1996 . 2 Ž . IMF executive Board Decision no. 539277r63 , adopted April 1977. The G-5 countries include: France, Germany, Japan, the United Kingdom, and the United States. ( ) K.M. Dominguez r Journal of International Money and Finance 17 1998 161]190 163 continued to intervene episodically throughout the rest of the 1980s and early 1990s. The scale of central bank intervention operations was large in the post-1985 period relative to previous history, but small relative to the overall size of the foreign exchange market. The most recent Bank for International Settlements Ž . BIS foreign exchange market survey suggests that the average daily volume of foreign exchange trading is now over one trillion dollars. By comparison, the average Fed intervention operation during the late 1980s involved $200 million. The BOJ and the Bundesbank have maintained a more consistent presence in the foreign exchange markets than has the Fed. The BOJ and the Bundesbank intervened steadily during the period before 1985 when the Fed was absent from the market. Germany was reported to have been the major initial force in starting the dollar on its decline in early 1985 through both its own intervention operations and its pressure on the US and Japan to join in coordinated operations. The BOJ seems to have been especially active in the foreign exchange market during periods in which the yen was appreciating against the dollar. Do intervention operations influence the volatility of exchange rates? Section 1 begins with a discussion of how central bank intervention policy can influence exchange rates. Section 2 describes two alternative approaches to measuring exchange rate volatility. Estimates of the influence of intervention on exchange rate volatility, as well as the influence of volatility on intervention, are presented in Sec. 3. Overall, the econometric results indicate that official G-3 exchange rate policy often significantly influenced exchange rate volatility over the past 18 years. Secret interventions are found to always increase volatility, while reported interventions have different effects on volatility depending on the central bank involved in the operation, the currency and the sample period. Section 4 presents conclusions. 1. Can central bank intervention influence exchange rates? Foreign exchange market intervention is any transaction or announcement by an official agent of a government that is intended to influence the value of an exchange rate. In most countries, intervention operations are implemented by the monetary authority, although the decision to intervene can often also be made by authorities in the finance ministry, or treasury department, depending on the country. In practice, central banks define intervention more narrowly as any official 4 The average unilateral sale of dollars by the Fed over the period 1985 through 1994 involved $190 million, and the average unilateral purchase of dollars involved $217 million. If all operations involving less than $100 million are excluded from the time series, the average dollar purchase was $312 million and the average dollar sale was $234 million. There were 4 days in 1994 when Fed dollar purchases Ž exceeded $1 billion dollars, the largest of these occurred on November 2, 1994 when the Fed purchased . $1600 million . The largest dollar sale occurred on May 18, 1989 when the Fed sold $1250 million. ( ) K.M. Dominguez r Journal of International Money and Finance 17 1998 161]190 164 sale or purchase of foreign assets against domestic assets in the foreign exchange market. Although each central bank has its own particular set of practices, intervention operations generally take place in the dealer market. During major intervention episodes, the Fed often chooses to deal directly with the foreign exchange desk of several large commercial banks simultaneously to achieve maximum visibility. As with any other foreign exchange transaction, trades are officially anonymous. However, most central banks have developed relationships with traders which allow them to inform the market of their presence within minutes of the original transaction, or to keep their intervention operations secret. Historical data on daily official Fed purchases and sales in the foreign exchange market have recently been made available, with a 1-year lag, to researchers outside the central bank. At this time no central bank systematically publishes contemporaneous intervention data. However, daily intervention operations are frequently reported in newspapers and over the wire services. So, although contemporaneous intervention data are unavailable from official sources, there exist numerous 7 Ž unofficial sources of the data. Secret interventions or interventions that central . banks choose not to make public are not differentiated in central banks’ official data, but one can roughly infer which operations were secret by comparing the official historical data with published reports of intervention activity in the financial press. Although traders may sometimes know that central banks are intervening without such knowledge appearing in the financial press, this relatively conservative accounting for reported intervention reveals that the bulk of recent intervention is not secret. In the empirical tests described in the next section I distinguish ‘secret’ and ‘reported’ interventions to examine whether the distinction matters in the volatility regressions. Regardless of whether interventions are made public, intervention operations may influence the domestic monetary base. Non-sterilized intervention operations involve a change in the domestic monetary base; they are analogous to open-market operations except that foreign, rather than domestic, assets are bought or sold. Sterilized operations involve an offsetting domestic asset transaction that restores the original size of the monetary base. The Federal Reserve Bank of New York is thought to fully and automatically sterilize its intervention operations on a daily basis. In practice, the foreign exchange trading room immediately reports its dollar 5 Ž . Dominguez and Frankel 1993c provide a detailed description of this process. 6 Daily Bundesbank intervention data have been made available to individual researchers; use of this data is typically subject to confidentiality agreements. My agreement with the Bundesbank involves presenting results using the German data in such a way so that individual daily operations are not revealed. 7 Ž . The Appendix to Dominguez and Frankel 1993c provides a listing of all the news of G-3 intervention Ž . activity as well as more general exchange rate policy announcements by central banks reported in the Wall Street Journal, the London Financial Times and the New York Times over the period 1982 through 1990. In this paper, the reported intervention activity and exchange rate policy news series are updated to include newswire reports available in NEXIS, and each series has been extended back to 1977 and forward to 1994. ( ) K.M. Dominguez r Journal of International Money and Finance 17 1998 161]190 165 sales to the open market trading room, which then sells enough bonds to leave the daily US money supply unaffected. The Bundesbank also claims to sterilize their foreign exchange intervention operations routinely as a technical matter. Nevertheless, the general perception is that both the Fed and the Bundesbank have at times allowed intervention operations to influence monetary aggregates } although the degree of monetary accommodation is limited to the extent that they both target their money supply growth. The BOJ generally declines to provide information on its sterilization policy. The standard monetary approach to exchange rate determination indicates that non-sterilized intervention will affect the level of the exchange rate in proportion to the change in the relative supplies of domestic and foreign money, just as any other form of monetary policy does. The effects of sterilized intervention are less direct and more controversial. In portfolio-balance models of exchange rate determination investors diversify their holdings among domestic and foreign assets based both on expected returns and on the variance in returns. According to the theory, as long as foreign and domestic assets are considered outside assets and are imperfect substitutes for each other in investor’s portfolios, an intervention that changes the relative outstanding supply of domestic assets will require a change in expected relative returns. This is likely to result in a change in the exchange rate. The second channel through which sterilized intervention can affect the level of exchange rates is known as the signalling channel. Intervention operations affect exchange rates through the signalling channel when they are used by central banks Ž . as a means of conveying or signalling , to the market, inside information } information known to central banks but not the market } about future fundamentals. If market participants believe the central bank’s intervention signals, then even though today’s fundamentals do not change when interventions occur, expectations of future fundamentals will change. When the market revises its expectations of future fundamentals, it also revises its expectations of the future spot exchange rate, which brings about a change in the current rate. The magnitude of 8 Ž . See Neumann and von Hagen 1992 for a detailed discussion of German sterilization policy. Germany and the US began to use monetary targets in 1975 and 1979, respectively. 10 Ž . Ž . Branson and Henderson 1985 and Henderson 1984 provide a survey and analysis of portfolio balance models. 11 Ž . One of the first descriptions of the signalling channel can be found in Mussa 1981 . 12 Interventions may signal information regarding monetary policy, or, more generally, as Friedman . 1953, p. 188 argued, intervention might usefully convey information whenever, ‘government officials have access to information that cannot readily be made available, for security or similar reasons, to Ž . private speculators’. Kenen 1987, p. 198 suggests that intervention signals may effectively ‘change the market’s confidence in its own projections . . . when expectations are heterogenous and especially when a Ž . bubble appears to be building’. Eijffinger and Verhagen 1997 suggest that interventions may convey Ž . Ž ambiguous signals about the central bank’s short-term exchange rate target which in itself may reflect . the central bank’s assessment of the possible future paths of fundamentals . 13 If the information revealed involves own future policy intentions, then sterilized intervention should not be considered an additional independent policy tool for central banks. The intervention operation may alter the timing or magnitude of the impact of monetary or fiscal policy on the exchange rate, but Ž . its effectiveness is not independent of those policies Obstfeld, 1990 . ( ) K.M. Dominguez r Journal of International Money and Finance 17 1998 161]190 166 the signalling effect of a sterilized intervention operation may exceed that of a non-sterilized operation, depending on the nature of the information that the signal conveys. It is standard to model exchange rates as forward looking processes that are expectationally efficient with respect to public information. The current spot rate can be represented as

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@inproceedings{Dominguez1998CentralBI, title={Central bank intervention and exchange rate volatility}, author={Kathryn M. E. Dominguez}, year={1998} }