Currency wars: Lessons from the US experience: 1973-95

Owen F Humpage, Michael Bordo 03 October 2011

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The disparate and ongoing impacts of the Great Recession have resulted in sharp exchange-rate changes as the large developed economies focus policy on their domestic situations. Threats of ‘currency wars’ linger, and some countries – notably Japan and Switzerland – have shown an interest in foreign-exchange intervention. The situation raises a perennial question: Does foreign-exchange intervention afford monetary authorities a means of systematically influencing exchange rates independent of their domestic policy objectives? The US experience during the floating-exchange-rate era suggests not.

Foreign-exchange intervention can be of two types. Nonsterilised intervention is an open-market operation conducted through foreign exchange and, as such, affects the level of bank reserves. It is tantamount to introducing an exchange-rate target into a central bank’s reaction function, but it also sets up the possibility for conflict between domestic and exchange-rate objectives. When, for example, short-term interest rates are at or near the zero bound, purchasing foreign exchange may provide a means of undertaking quantitative easing (McCallum 2003). In such cases, the exchange-rate objective – depreciation or avoiding appreciation – and the domestic monetary goal – easing policy – are compatible. But if a country’s currency is appreciating because of monetary policies abroad, as in Brazil, nonsterilised intervention to prevent a currency appreciation will create inflation at home. Because of this potential for conflict, and because there are usually better assets for conducting open-market operations, countries generally eschew nonsterilised intervention (Neely 2001 and 2007, Lecourt and Raymond 2003).

Sterilised intervention does not affect bank reserves. Since sterilised intervention has no effect on the money stock – a key determinant of exchange rates – observers often wonder how it might actually affect exchange rates. Economists have suggested two principal transmission mechanisms: the portfolio-balance and the expectations channels.

Sterilised intervention affects the currency composition of privately held government securities. The act of sterilising an intervention increases outstanding government securities denominated in the currency that central banks are selling relative to government securities denominated in the currency that central banks are buying. If risk-averse asset holders view these securities as imperfect substitutes, they will only hold the relatively more abundant asset if the expected rate of return on that asset compensates them for the perceived risk of doing so. Their initial reluctance to hold the relatively more abundant security forces a spot depreciation of the corresponding currency. The spot depreciation relative to the exchange rate’s longer-term expected value then raises the anticipated rate of return on the now more abundant securities and compensates asset holders for the perceived increase in risk.

The portfolio-balance mechanism conceivably could provide central banks with a channel for affecting exchange rates independent of their domestic policy objectives. Unfortunately, however, most empirical studies find the relevant elasticities to be either statistically insignificant or quantitatively negligible (Edison 1993). Dominguez and Frankel (1993) is a notable exception. Central banks do not put much stock in the portfolio-balance channel (Neely 2007).

Alternatively, sterilised intervention might affect market expectations. Exchange markets are highly efficient processors of information, but not perfectly so. Information is costly and, at any time, asymmetrically distributed. Large foreign-exchange traders appear to have an informational advantage derived from a broader customer base and market network (Cheung and Chinn 2001). In markets characterised by information asymmetries, non-fundamental forces may affect short-term exchange-rate dynamics, and any trader that others suspect of having superior information, including monetary authorities, could affect the price if market participants observed his or her trades. The actions of any trader with a consistent informational advantage should have value as a forecast of near-term exchange-rate movements.

With this transmission mechanism in mind, we tested to see if US intervention between 1973 and 1997 had forecast value with respect to two simple criteria – both consistent with stated objectives of US intervention – and a general criterion that combined the two (Bordo et al 2011). The criteria and results appear in Table 1. Over that time, the US intervened on 971 days against German marks and on 243 days against Japanese yen. Approximately 60% of all US interventions were successful under one or the other criterion – an amount that was not different from what we would have randomly anticipated given the volatile nature of day-to-day exchange-rate changes. The overall results mask two distinctive outcomes: 

  • First, US purchases and sales on foreign exchange show no systematic correspondence with dollar depreciations or appreciation, respectively.

Sometimes US intervention had just the opposite effect, suggesting that speculators could have profited by betting against the operation.

  • Second, and more favourably, US intervention often accompanied a same-day moderation of dollar exchange-rate movements in a manner broadly consistent with leaning against the wind.

While generally greater than random, the number of successes under the second criterion accounted for less than one fourth of all US interventions. When we tested over various sub-periods, these results were not materially changed.

Conclusion

The results suggest that sterilised intervention does not afford monetary authorities a means of systematically affecting their exchange rates independent of their domestic policy objectives. Intervention is more of a hit-or-miss proposition than a sure bet. Countries that engage in currency wars run a real risk of shooting themselves in the foot.

Table 1. 

Please click image to enlarge

References

Bordo, MD, O Humpage and AJ Schwartz (2011) “ The Federal Reserve as an Informed Foreign Exchange Trader: 1973-1995” NBER Working Paper 17425. September.

Cheung, Y, and MD Chinn (2001) “Currency Traders and Exchange Rate Dynamics: A Survey of the US Market.” Journal of International Money and Finance 20 (4): 439-471.

Dominguez, KM, and JA Frankel (1993a) “Does Foreign-Exchange Intervention Matter? The Portfolio Effect.” American Economic Review 83 (5): 1356-1369.

Edison, H (1993) "The Effectiveness of Central Bank Intervention: A Survey of the Literature after 1982." Princeton University, Special Papers in International Economics 18.

LeCourt, C, and H Raymond (2006) “Central Bank Interventions in Industrialized Countries: A Characterization Based on Survey Results.” International Journal of Finance and Economics 11(2): 123-138.

McCallum, BT (2003) “Japanese Monetary Policy, 1991-2001.” Federal Reserve Bank of Richmond Economic Quarterly 89 (1): 1-31.

Neely, CJ (2001) “The Practice of Central Bank Intervention: Looking Under the Hood.” Central Banking 11 (2): 24-37.

Neely, CJ (2007) “Central Bank Authorities Beliefs about Foreign Exchange Intervention.” Journal of International Money and Finance 27 (1): 1-25. 

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Topics:  Exchange rates

Tags:  US, Currency wars, sterilised interventions

Professor of Economics, Rutgers University

Owen F Humpage

Senior Economic Advisor, Research Department, Federal Reserve Bank of Cleveland