Research by Rasmus Fatum and Michael Hutchison, published in the latest
issue of the Economic Journal, provides strong new evidence that official
intervention in foreign exchange (forex) markets is an effective way for central
banks to manage exchange rates, even if it is not backed up by interest rate
changes or other actions.
Conventional wisdom holds that official intervention not taken in tandem with
central bank monetary policy (‘sterilised intervention’) has little impact on the
exchange rate and is therefore a waste of time and of the government’s
reserves of foreign exchange.
Despite academic scepticism, most central banks nonetheless actively
intervene in foreign exchange markets. Are these policies misguided and
central bankers irrational? Or is evidence showing the effectiveness of
sterilised intervention being overlooked?
The study by Fatum and Hutchison, which examines the outcomes of various
interventions in the daily US dollar/D-mark market by the Bundesbank and
Federal Reserve, shows that intervention is effective when used selectively
and directed to short-run objectives. Exchange rate management by actively
intervening in the forex market is not dead, as long as the authorities have
limited objectives, co-operate with other central banks and are persistent!
Fatum and Hutchison look at intervention ‘episodes’ – periods of several days
running when intervention is intense and persistent – and link intervention with
systematic exchange rate changes. Focusing on daily Bundesbank and
Federal Reserve official intervention operations, they identify separate
intervention ‘episodes’ and analyse the subsequent effect on the exchange
rate.
They find that intervention operations are usually successful in either slowing
or reversing the direction of exchange rate change – the objective of most
central banks – over periods of up to two weeks. For example, the
Bundesbank entered the market on 26 ‘episodes’ in response to either an
appreciating or deprecating D-mark, and 24 of these interventions (D-mark
sales or purchases) over the period 1985-95 (daily data) were successful. The
odds of this rate of success being ‘random’ are less than 1%.
Not surprisingly, intervention supported by central bank interest rate changes
has an even larger impact than intervention alone – but both are effective in
moving exchange rates.
Similarly, cases where intervention was co-ordinated between the
Bundesbank and the Federal Reserve – both central banks in the market at
the same time – had a larger impact on exchange rates than unilateral forex
operations. Furthermore, the likelihood of success was greater the larger the
volume of intervention and the longer the central bank was persistently ‘in the
market’.
Why do these researchers find that intervention is effective in moving the
exchange rate over periods of several days to several weeks when other
studies have failed to find a link?
The main reason, the authors explain, is methodological. Previous work has
tried to link the intense and sporadic bursts of intervention activity episodes
that occur infrequently against exchange rates that change almost
continuously on a daily basis. The episodic approach employed by Fatum and
Hutchison, an event study framework, is better suited to detecting statistical
linkages in these circumstances – as long as the focus is on short-term
exchange rate changes.
There are costs and benefits to using any methodology, and the great benefit
of this approach is that it is able to find a connection in a simple and intuitive
way between intervention and exchange rate fluctuations. The cost is that an
event study methodology does not allow identification of the particular channel
through which intervention works. In other words, it isn’t able to tell us much
about why intervention works, distinguishing between alternative
explanations.
Nevertheless, Fatum and Hutchison point out that their findings are consistent
with recent research that interprets intervention as a means to ‘signal’ not only
future policy but also the central bank's views on the fundamental or
equilibrium value of the exchange rate.
ENDS
Notes for Editors: ‘Is Sterilised Foreign Exchange Intervention Effective After
All? An Event Study Approach’ by Rasmus Fatum and Michael Hutchison is
published in the April 2003 issue of the Economic Journal.
Fatum is at the University of Alberta School of Business; Hutchison is
Professor of Economics at the University of California, Santa Cruz, Santa
Cruz, CA 95064 (http://econ.ucsc.edu/~hutch/).
For Further Information: contact Michael Hutchison on +1-831-459-2600
(fax: +1-831-459-5900; email: hutch@ucsc.edu); or RES Media Consultant
Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email:
romesh@compuserve.com).