Foreign Exchange: The Complete Deal - James McDowell. Sharpe

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problem central banks face is the market perception that they have set an exchange rate level to protect (commonly referred to as a line in the sand). This invariably tempts the market to test resolve and pockets of the central bank by continuing to buy or sell.

      During the period in which countries followed 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 was left to the discretion of individual countries. It was not until 1977 that the IMF provided its member countries three principles to adhere to in their intervention policy. [3] The principles said that countries should:

      1 not manipulate exchange rates in order to prevent balance of payments adjustment or to gain unfair competitive advantage over others

      2 intervene to counter disorderly market conditions

      3 take into account the exchange rate interests of others.

      These principles implicitly assume that intervention policy can influence exchange rates.

      The US was actively involved in intervention during the 1970s but was absent from 1981 through 1984. However, in early 1985 after the dollar had appreciated by over 40% and the US trade deficit was approaching $100bn, the Federal Reserve (Fed) in the US joined with the German Bundesbank (BUBA) and the Bank of Japan (BoJ) to intervene against the dollar. In the autumn of 1985 the US and the rest of the G-5 (Germany, Japan, France and the UK) engaged in a number of large and coordinated operations as part of the Plaza Agreement. While the scale of central bank intervention was large in the post-1985 period relative to previous history, it was still small in relation to the overall market. The Plaza Agreement stated:

      “In view of the present and prospective changes in fundamentals some orderly appreciation of the main non-dollar currencies against the dollar is desirable. The Minister and Governors stand ready to cooperate more closely to encourage this when to do so would be helpful.” [4]

      During the period 1985-1987 the dollar fell by over 50% against the Deutschmark. Throughout the period the central banks’ stated intention was to affect the level rather than the variability of exchange rates. However, in February 1987 the G-7 produced the Louvre Accord which stated that nominal exchange rates were “broadly consistent with underlying economic fundamentals” and should be stabilised at their current levels. [5]

      Sterilised and unsterilised intervention

      Intervention can be distinguished by whether it is sterilised or unsterilised; i.e., intervention that respectively does not or does change the monetary base (or money supply as an approximation). When a monetary authority buys (sells) foreign exchange its own monetary base increases (decreases) by the amount of the purchase (sale). If the authority wishes to reverse the effect on the domestic monetary base – sterilise – they would buy (sell) domestic bonds. Fully sterilised intervention does not directly affect prices or interest rates and so does not influence the exchange rate through these variables as ordinary monetary policy does.

      Unsterilised intervention is effectively another way of conducting monetary policy; in other words it will affect the level of the exchange rate in proportion to the change in the relative supplies of domestic and foreign money. A currency swap can be used to sterilise an intervention. A swap is a transaction where a foreign currency is bought in the spot market and simultaneously sold in the forward market. A swap will have little affect on the exchange rate. In this process the spot leg of the swap is transacted in the opposite direction to the spot market intervention, leaving the forward leg intact.

      How intervention is carried out

      The forward market has been used on a number of occasions for intervention purposes. This is the purchase or sale of foreign exchange for delivery at a future date. Intervention in the forward market has the advantage that there is no immediate cash outlay and therefore the impact on domestic liquidity (and the need for sterilisation) is at least delayed until the maturity of the foreign exchange contracts. Public reports indicated that the Bank of Thailand used this to defend the baht in 1997 (Moreno 1997).

      Options have been used in a few cases (such as in Mexico in August 1996) to intervene in the exchange market, but not recently. As is the case with forwards, options do not immediately change the level of reserves and therefore do not require sterilisation. However, in so far as intervention operates through signalling the intentions of central banks, transactions involving options may not quite have the desired visible impact. The spot market is the favoured vehicle.

      Intervention and monetary policy

      The impact of floating exchange rates on monetary policy (the process by which the monetary authority of a country controls the supply of money) has changed over the years. Initially monetary policy under floating exchange rates was characterised by targeting money growth. Interest rates were set to limit growth in monetary aggregates, which was viewed as the key to price stability. Since the exchange rate was not an explicit part of this strategy, foreign exchange interventions were not required.

      The arrival of inflation targeting in the 1990s significantly challenged the one-variable approach; instead, all variables that might influence future inflation were taken into account in setting monetary policy. In this context the degree of exchange rate pass-through to domestic prices determines the extent to which the central bank will have to incorporate exchange rate movements in their decision process. If the exchange rate is important for future inflation (i.e., the pass-through effects of exchange rate changes on inflation occur faster than the interest rate effects on inflation) then it follows that intervention might be a useful instrument.

      How monetary policy is conducted

      Monetary policy can operate through monetary targeting, exchange rate targeting or inflation targeting. A monetary targeting strategy will have an implicit inflation target, which is used to determine the optimal growth of the monetary aggregate. Central banks that pursue exchange rate targeting do not require a target rate for inflation. Ideally, the exchange rate would be pegged to a low inflation currency with the aim of mirroring their inflation performance; as such there is no need to specify an inflation target rate.

      This is quite the opposite of inflation targeting, where there is a specific figure announced and widely communicated. In this case there is no interim target for the public to observe, which of course raises the profile of the final target. Practically, all three strategies are managed through short-term interest rates.

      A recent approach has been to take account of all indicators, known as a look at everything strategy, rather than a single variable. This is very much allied to improved communications (signalling) between the policy makers and the public, and genuine accountability. In the UK this is seen in the letter that is sent from the Bank of England Governor to the Chancellor if inflation deviates over 1% from target.

      One common feature in this transparent approach is the publication of minutes of monetary meetings, albeit with a time lag. It is important that the public believe in the policy makers’ commitment; anchoring inflation expectations is viewed as critical by all central bankers in public utterances and in official reports. The implicit assumption in inflation targeting is that low and stable inflation will promote macroeconomic goals such as economic growth and employment. Inflation targets are generally around 2% and are either published as a single figure or as a target range.

      Events of 2008 and 2009 highlighted that monetary policy is not exclusively about preventing excessive inflation; many central banks at this time were looking to counter deflationary pressures (a decline in prices and weak growth) and in some cases sold their currency. Another good example of this is the Japanese policy response in 2001 to a decade long period of near zero growth and deflation. The policy conclusion was that the key to recovery was an expansion of the money supply. This was started in March 2001 by the adoption of quantitative easing (a term which has come into the public domain following the 2007-09 financial crisis). This was followed up by

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