MANAGING EXCHANGE RATES: OFFICIAL INTERVENTION WORKS
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 circumsta nces – 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).