What Can Central Banks Do About the Value of the …...What Can Central Banks Do About the Value of...

What Can Central Banks DoAbout the Value of the Dollar?Dallas S. Batten and Mack Ott

VER the past four years, the stubborn strength of

the U.S. dollar in foreign currency markets has createdwhat many observers believe is a precar’ious balancebetween two undesirable features of the floating ex-change rate system. On the one hand, some argue thatthe dollar’ is overvalued and, consequently, soon willfall dramatically, generating increased U.S. inflationand jeopardizing world financial stability. On the otherhand, other-s asgue that the “high” dollar was a majorcause of the 1981—82 economic recession and nowassert that the cur-rent expansion is not sustainablewithout a substantial decline in the foreign exchangevalue of the dollar.’

Surpsisingly, both sets of dollar critics have ad-vanced the same policy prescription: intervene in fos-eign exchange mas-kets. In other- words, the monetary

Dallas S. Batten and Mack Ott aresenior economists atthe FederalReserve Bank of St. Louis. Paul G. Christopher provided researchassistance.

‘For examples, consider Kraus (1984), Arenson (1984) and Bank forInternational Settlements (1984). In the last (p. 1), Dr. Gleske, amember of the Directorate of the Deutsche Bundesbank, was some-what bemused by the dollar’s persistent high value:

There therefore seem to be enough reasons to support expectationsthat the dollar rate will decline. However, contrary to all historical experi’ence, these expectations have not been fulfilled as yet. The markets donot seem to have any expectations of this nature, either. Apparently,investing in dollar assets — especially in the united States itself —

continues to be lucrative despite the greaterexchange rate risk, and themarkets appear up to now to have hardly any doubts that the dollar willremain attractive despite the tact that the fundamental factors like thedeclining competitiveness of U.S. industry and sharply rising current-account deficits operate rather in Savour ot expecting the opposite.

authorities of the United States and its major tradingpartners should buy and sell foreign currencies. Thefirst set of critics urges this policy to manage the fall ofthe dollar’s foreign exchange value, while the secondurges it to bring down the value of the dollar in order tostimulate the U.S. traded goods sectors.2

The purpose of this paper is to explain the fun-damentals of cents-al bank intervention in foreign ex-

change mam-kets and the conditions required for it to beeffective. First, the motives, mechanics and conse-quences of intervention are discussed. Next, the rela-tionship between intervention and domestic monetary

policy is investigated. Finally, some qualitative andquantitative evidence on the efficacy of intervention isreviewed.

WHY CENTRAL BANKS INTERVENE

The exchange rate is the price of one country’s cur-mency in terms of another. As the relative price of twoassets (currencies), it is determined by the fos-ces ofdemand and supply, as are the prices of other assets,

‘Traded goods are those goods that are potentially exportable orimportable — whether or not they are actually oonsumed domestical-ly or abroad. For instance, agricultural commodities, airplanes andsteel are tradedgoods, while haircuts, legal servicesand housing areprimarily nontraded goods. The importance of the distinction be-tween traded and nontraded goods is that changes in foreign com-petition will directly affect production and sates both in the home andforeign markets in the traded goods sector, while only indirectlyaffecting produotion and sales in the nontraded goods sector.

16

FEDERAL RESERVE BANK OF ST. LOUIS MAY 1984

such as stocks, bonds or real estate.3 Moreover, therelative valuations of and yields on non-currencyassets also have, as we shall see, large impacts on theexchange rate.

Unlike the prices of services or nondurable goods,asset prices reflect primarily the market’s expectationsabout future economic conditions. Consequently, inthe short run, exchange rates should be influencedpredominantly by new information — that is, surprises— which alters expectations of future events; thesesurprises lead to highly unpredictable and often siz-able movements in exchange rates. Because news canbe incorrect and because markets can oyerreact tonews even when it is correct, monetary authorities

typically believe that much of the short-run volatilityexhibited by foreign exchange markets is excessive.4

Consequently, intervention is frequently rationalizedby central banks as a means to reduce the presumed

excessive variability of exchange rate movements re-sulting from the variability of market expectations.5

In the long run, movements of exchange rates tendtoward a relationship among currencies known as pur-

chasing power parity (PPP). That is, a dollar or yen ordeutsche mar-k 1DM) would each purchase the sameamount of goods whether expended at home orabroad. Thus, a country with a relatively rapid inflationrate will have its currency decline in value relative to

the currencies of countries with slower inflation rates.

Ignoring long-run considerations, frequent andoffsetting exchange rate movements in the shor’t or

‘Policymakers sometimes argue that it is too important to be deter-mined solely by market forces. Consider, for example, the view of Dr.Otmar Emminger, former President of the Deutsche Bundesbank, asexpressed in a speech to a Bankers’ Forum at Georgetown Universi-ty, Washington, D.C., on September 28, 1981 (see Bank for Interna-tional Settlements [1982], p. 4):

The exchange rate is tar too important a price — because of its effectson domestic stability and activity, the balanceof payments, and interna-tional trade and payments relations —to betreated with ‘benign neglect’as a ‘residual outcome’ of domestic monetary and other economicpolicies. This should not be misunderstood as a call for activism andinterventionism in the field of exchange rates, It cannot be emphasisedtoo much that the most important foundation for exchange rate stabilityis a policy of monetary and financial stability at home. We would,however, delude ourselves it we believed that all that is required forstable exchange rates is the pursuit of a steady money supply policy.Short and medium-term strains and disturbances are built-in elementsin the field of payments and exchange markets, even if we had firminternational agreement and successful implementation of concertedmoney supply policies.

4This concern, however, appears to be misdirected as Bergstrand(1983)has demonstrated that exchange rates are actually less vari-able than other asset prices.

5For additional supportforthis characterization, see Kubarych (1983),pp. 16—19 and 43—45.

intermediate term can be more than just a nuisance tomonetary authorities—they also can have real effects.For example, an appreciation of the exchange rate

beyond that necessary to offset the inflation differentialbetween two countries (termed “overshooting”) raisesthe price of traded goods in the home country relative

to the prices of traded goods in the rest of the world.Thus, home country exports become less competitivein world markets and home country import substitutesless competitive in domestic markets. Consequently,sales of traded goods decline, generating unemploy-ment in the traded goods sector and, subsequently,inducing a shift of resources from the traded to thenontraded goods sector.

This reallocation of resources is efficient for theeconomy ifthat portion of the exchange rate apprecia-tion in excess of the inflation differential is permanent.If this excess portion of the exchange rate appreciationis short-lived i.e., reversed in the near futurel, thecorresponding movement of resources will be re-versed, and the economy will have experienced un-necessary unemployment due to the costs of shiftingresources, reallocating capital, laying off and hiring.Monetary authorities who wish to avoid such situa-tions may intervene to oppose exchange rate move-ments that they believe will riot persist. This is a fea-sible policy, however, oni if they can distinguishtemporary exchange rate fluctuations from permanentones.°

Exchange rate changes also affect the general pricelevel and may gener-ate some measured short-run in-flation or- disinflation as markets adjust to the changingrelative price of traded to nontraded goods. In particu-lar, an exchange s-ate depreciation raises the domesticcurrency pt-ice of imports and, thus, raises the domes-tic price level.Because the total impact of this change isnot felt all at once, the price level continues to rise forsome time. Thus, since exchange rate depreciationusually precedes changes in domestic prices, it mayappear to cause inflation.’

6This distinction is difficult to make in practice. As Martin Feldstein(1983), p. 48, observed:

[Tlhere is no way in practice to distinguish an exchange-rate movementthat is merely a random fluctuation from one that is part of a fundamentalshift in the equilibrium exchange rate, Exchange-market interventionaimed at smoothing a transitory disturbance may in fact be a counterpro-ductive or futile attempt to prevent a basic shift in the equilibrium ex-change rate.

Furthermore, this overshooting may 000ur because asset marketsclear more rapidly than dogoods markets, and, as a result, it may notbe undesirable.

‘For a more detailed discussion of the relationship between domesticinflation and exchange rate changes, see Batten and Ott (1983).

17


Finally, many domestic residents, firms and, espe-cially, multinational corporations have financial assetsand liabilities denominated in foreign currencies. Ex-change rate changes, then, produce wealth effectssince they generate capital losses and gains. For exam-ple, if the U.S. exchange rate unexpectedly appreciates,the dollar values of foreign-currency-denominated

assets and liabilities fall. Hence, U.S. net monetarydebtors in foreign currencies experience gains, and netcreditors experience losses?

In sum, changes in exchange rates have conse-quences that monetary authorities may deem unde-sirable. Thus, having chosen not to allow exchangerates to be completely market-determined, many cen-tral banks intervene periodically in foreign exchange

markets to mitigate what they believe to be transientbut deleterious effects of exchange rate movements onthe domestic economy.

HOW CENTRAL BANKS INTERVENE

The mechanics of central bank intervention in for-eign exchange markets can take a variety of forms. Thegeneral purpose of each variant, however, is basicallythe same: augment the market demand for one curren-cy by augmenting the market supply of another. Anexhaustive explanation of the ways in which interven-tion can be conducted is beyond the scope of thispaper? Instead, we will describe the most ftequently

eA net monetary foreign currency debtor is an individual or firm withgreater monetary debts than monetary claims in a foreign currency.Thus, when that foreign currency depreciates, his foreign liabilitiesdecline in value more than his foreign assets, and, on net, his wealthrises. Similarly, a foreign currency depreciation would lower thewealth of a net monetary foreign currency creditor.

°SeeBaibach (1978) for a detailed analysis of various forms of in-tervention.

employed method — intervention by the monetaryauthority.

it Typical Example

Suppose that the dollar is believed to be overvalued.The Federal Reserve Bank of New York, which acts asthe agent for U.S. foreign exchange market interven-tions, will purchase foreign currency, typically PM,with U.S. dollars.1° It can do this simply by creatingdollar reserves and using them to purchase PM. Inparticular, the Fed can purchase PM-denominated de-posits of U.S. banks at German banks and pay for themby crediting the reserve accounts of these U.S. banks.The Fed then presents to the Bundesbank drafts drawnagainst accounts of these U.S. banks at German banks,which are subsequently cleared by the Bundesbank.The impact of this transaction on the financial institu-tions involved is outlined in figure 1. In gener-al, thereserves of the U.S. banking system increase, whilethose of the German banking system fall. The changesin the reserve positions of the United States and Ger-many that result from this foreign exchange operationwill cause the U.S. money stock to rise and Germany’smoney stock to fall.

Conversely, if the Bundesbank believes the PM tobe undervalued (i.e., the dollar- is overvalued), it couldreduce the quantity of PM relative to dollars. Thistransaction is slightly more complicated than whenthe Fed intervenes in support of the PM. First, theBundesbank must acquir-e dollars. It typically does thiseither by selling some of its non-negotiable U.S. Trea-sury securities to the Fed or by borm-owing from the

‘°Inthe United States, the Federal Reserve Bank of New York inter-venes for the Federal Reserve System and the U.S. Treasury. Thedecision to intervene, however, is made by the U.S. Treasury.

18


Fed in exchange for a dollar-denominated accountthrough a swap arrangement already established be-tween the two. These acquired dollars are then used tobuy PM in the foreign exchange market.

In figure 2, step 1 depicts the acquisition by the

Bundesbank of a dollar--denominated deposit at theFed. Since this tr-ansaction is between central banks, itdoes not affect the reserves of the banking system ineither country and, hence, does not affect either- coun-

tsy’s domestic money supply. In step 2, the Bund-esbank purchases PM-denominated deposits of U.S.

commercial banks held at German commercial bankswith dollars. This transaction is cleared by U.S. banks

presenting to the Fed dollar-denominated claimsagainst the Bundesbank and receiving reserves in re-

turn. (At the same time, the Fed reduces its depositliabilities to the Bundesbank.) Likewise, the Bund-esbank clear’s the draft it purchased from U.S. banks bylowering its reserve liabilities to Get-man banks. Andfinally, German banks, presented with a draft against

deposits of U.S. banks, r-educe their deposit liabilities tothese banks by the amount of the reduction in theirreserve deposits at the Bundesbank. The final result is

the same as in the preceding case — the r-eserves of theU.S. banking system rise, while those in the Germanbanking system fall.

Sterilized vs~Unsterilized Intervention

The two examples discussed above are instances ofunsterilized intervention; that is, the domestic moneysupplies have not been insulated from the foreign ex-change market transaction. Ifunsterilized interventionis undertaken in large amounts, it will affect not onlythe money supplies of both countries, but domesticprices and interest rates as well. If monetary author-

ities do not want their foreign exchange market in-tervention to affect their domestic economies, theymay sterilize its impact with an offsetting sale orpurchase of domestic assets

Sterilized intervention would be the preferred pro-

cedure if the Fed did not want the U.S. banking sys-tem’s reserves to change. Thus, if the unsterilizedintervention interfered with the goals of domesticmonetary policy, the Fed could sell US. Treasury

securities in U.S. financial markets equal to the amountof reserves created by the intervention. With this trans-action, the level of reserves in the U.S. banking systemwould return to its preintervention level, and, as aresult, there would be no subsequent change in the

U.S. money supply.

Similarly, the Bundesbank could neutralize the im-

pact of intervention on the German money supply byinjecting new reserves into its banking system. Ifsteril-ized completely, the foreign exchange operationwould not affect either country’s money supply. Thus,in the case of a completely sterilized intervention,private portfolios would contain fewer PM-

denominated securities and more dollar-denominatedsecurities, while the Fed’s portfolio would containmore PM-denominated securities and fewer dollar-denominated ones.

THE EXCHANGE RATECONSEQUENCES OF CENTRALBANK INTERVENTION

Exchange rate movements reflect two fundamentalcharacteristics that must be recognized to understandthe impact of intervention. First, changes in exchangerates, like changes in the price of any asset, are highly

19


irregular and unpredictable in the short run, reflectingprimarily new events that alter the market’s expecta-tions of future exchange rate movements. Second,since the exchange rate is the relative price of twocurrencies, its movements reflect changes in policiesthat affect either the supplies ofthese currencies or thedemands to hold them. More specifically, exchangerates reflect anticipated relative inflation rates that are

generated by both past and expected future policyactions of the countries involved.Therefore, currenciesof countries with lower expected inflation rates arecheaper to hold and are in greater demand than thoseof countries with higher inflation rates, all other thingsequal. Consequently, it follows from PIt that curren-

cies of higher-inflation countries tend to depreciaterelative to those of lower-inflation countries.

The different impacts of sterilized and unsterilizedintervention on the exchange rate can be analyzed interms of these two characteristics. Suppose, as out-lined above, that either the Fed or the Bundesbankpurchases PM with U.S. dollars. This transaction in-creases the short-run flow demand for PM relative tothe supply of PM and should result in an appreciationof the PM, all other things equal. This impact will beonly transitory, however, unless the central bank con-tinues to purchase PM day afterday, ther-eby maintain-

ing the higher flow demand for PM.

More importantly, since this tr-ansaction is unsteril-ized, it causes the U.S. money supply to rise and theGerman money supply to fall. If large enough, thisintervention has two potential effects: a transient effecton the current markets for the two currencies and apermanent effect on expected future relative inflationrates. Other things equal, the resulting excess supply ofU.S. money in the United States and excess demand for

German money in Germany will cause the two coun-tries’ money markets to clear at lower and higher- ratesofinterest, respectively. This immediate, but transitory,effect will cause the dollar to decline relative to the PMas German assets temporarily have higher yields thanU.S. assets.

Whether this effect on the exchange rate is lasting ortransient, however, depends crucially on the expecta-tions of investors holding U.S. and German assets. Ifthese expectations are unchanged, individuals holdingU.S. assets would sell them — driving up theiryields —

and buy German assets — depressing their yields —

thereby tending to offset the central bank’s actions.That is, just as a single private individual in a competi-

tive market can have no effect on asset prices by hissales or purchases, so even central banks will not affect

asset prices unless their activity is substantial or theiractions affect market expectations.

This intervention may affect market expectationsabout relative asset yields and prices if market partici-

pants interpret the expansion of the U.S. money supplyas an indicator of a permanent increase in the rate ofmonetary growth planned by the Fed. Such expecta-

tions of further easing of U.S. monetary policy willcause market participants to anticipate increases inthe rate of U.S. inflation relative to German inflation.These expectations ofrelatively higher future U.S. infla-tion will decrease the desire of foreigners to hold dol-lars since they expect the dollar’s purchasing power to

continue to fall. Consequently, the PM value of thedollar will depreciate at a rate equal to the differencebetween the now higher anticipated rate of inflation inthe United States and that in Germany.11

Ifthe intervention is sterilized, its immediate impactis the same as that for unsterilized intervention; that is,it generates a temporary increase in the flow demandfor PM. The net effect of this sterilized intervention issimply that private portfolios will contain more dollar-denominated and fewer PM-denominated securities;neither country’s money supply will be affected. Con-sequently, it is not clear what lasting impact this type ofintervention will have on the PM/dollar exchange rate.

Because sterilized intervention entails a substitution

of dollar-denominated securities for PM-denominatedones, however-, the exchange rate will be permanentlyaffected only if the investors view domestic and foreign

securities as being imperfect substitutes. If this is thecase, investors will be unwilling to hold the new port-folio at unchanged exchange and interest rates. In fact,at the original exchange and interest rates, an excessdemand for PM-denominated securities will arise.Consequently, investors will attempt to acquire addi-tional PM-denominated securities in order- to retur-ntheir portfolios to the desired proportion of dollar’-denominated securities, ther-eby placing downwardpressure on the PM value of the dollar.

If investors consider these securities to be perfectsubstitutes, on the other hand, no change in either the

“This discussion is oversimplified in that it isolates only two curren-cies and the exchange rate between them. In the real world, thereare numerous currencies and exchange rates. Attempts to affect theexchange rate between any pair of currencies necessarily affect notonly the exchange rate between this pair, but all other exchangerates as well. Consequently, intervention to move one exchangerate in a desirable direction or to calm fluctuations in that exchangerate may cause another exchange rate to move in an undesirabledirection or to become more volatile.

20


exchange rate or in interest rates will be necessary tomotivate investors to hold this portfolio. In summary,when two domestic money supplies have been un-affected by an intervention activity, the interventioncan have a permanent impact on the exchange rateonly if foreign and domestic securities are imperfectsubstitutes.

INTERVENTION AND DOMESTICMONETARY POLICY

The foregoing discussion has emphasized that therelationship between domestic monetary policy andintervention depends on whether the intervention issterilized. Pomestic monetary policy cannot be con-ducted independently of unsterilized interventionsince, as discussed above, it is tantamount to conduct-ing monetary policy through foreign exchange marketoperations. Thus, the exchange rate is a third alterna-tive monetary target variable to those more frequentlyconsidered — namely, monetary aggregates or interestrates.

Because there can be only one monetary policystance, the role of unsterilized intervention dependscrucially on the importance that policymakers place

on the exchange rate as an objective for monetarypolicy. In particular, the use of unsterilized interven-tion necessarily implies that the monetary authorityplaces relatively more importance on reducing therisks and real economic disturbances associated withexchange rate movements than achieving domestictar-gets for- inflation and unemployment. The manip-ulation of monetary policy to achieve exchange rateobjectives inevitably will conflict — occasionally orfrequently — with the policy stance required to

achieve these domestic objectives.

Fur-thermore, exchange rate movements may bemotivated not only by changes in the desire to hold

domestic currency which probably should be offsetby changes in the domestic money supply), but also by

a host of other factors, especially the policies followedby foreign policymakers. Pirecting domestic monetarypolicy at an excharlge rate target, then, subjects thedomestic economy to disturbances from both domes-

tic and foreign sources. Consequently, the monetaryauthority loses its ability to control its own moneysupply independently of foreign events.

The desire to influence exchange r-ate movementswrthout losing control of the domestic money supply is

the primary motivation for using sterilized interven-tion. Whether a monetary authority can separ-ate cx-

change rate management from money stock control,

however, depends on whether certain conditions aremet. First, international assets (including currencies)must be imperfect substitutes. Second, the magnitude

of sterilized intervention undertaken must be largeenough — given the degree of imperfect substitutabil-

ity — that market participants cannot undo this effectby engaging in offsetting transactions.

SOME EVIDENCE ON THE

EFFECTIVENESS OF INTERVENTION

Assessing the efficacy of intervention is difficult be-cause data on central bank intervention are not madeavailable; in contr-ast to domestic central bank transac-tions, which are reported in great detail, internationaltransactions are reported only in a non-systematic,summary form. Three pieces of qualitative evidence,however, can be used to gauge the likely effectivenessof intervention. The first is an indirect assessmentobtained by considering adomestic policy experiment,somewhat analogous to sterilized intervention, whichoccurred in the early 1960s. The second is an assess-ment of the potential for the U.S. tnonetary authoritiesto influence the foreign exchange market by compar-ing the volume of assets and the rate of transactions inthese markets by private investor’s with the monetaryauthority’s holdings and activities. The third is a directassessment of U.S. and other central bank interventionactivity revealed in a working group study prepared forthe 1983 Williamsburg Economic Summit Meeting.

An Analogous Policy: Operalion Twist

A historical example of a domestic policy experi-ment by the Federal Reserve that is similar to sterilizedintervention is Operation Twist.” Puring 1961-432, theFederal Reserve sold short-term U.S. securities andused the proceeds to buy long-term U.S. securities; aswith sterilized intervention, the transactions wereoffsetting so that the money supply was unchanged.‘rhe resulting increase in short-term gover-nmentsecurities and the concomitant decline in long-termgovernment securities in private portfolios were in-

tended to raise the yield on short-term securities andlower the yield on long-term securities, thus, twist-ing” the term structure.12

In this effort, the first condition discussed above wasmet — namely, long-term securities bear higher- in-

terest rates than short-term securities, and, thus, the

‘2See Markiel (1966), pp. 219—43.

21


Chart]

Relative Stocks of Holdings of Foreign AssetsBillions of dollars800

Billions of doltors

100

0

Private U.S. nondomeslic asse(s Li. —-Foreign-owned assets in the United Stales LI.

U.S. total foreign reserves minus gold L~

LI Year-end outstanding.~ Annual averages at quarterly data.

NOTE, Direct investment data priar to 977

1980 1981 1982Reserve System and u.s. Department al Commerce

100

600

500

400

300

200

100

two assets are imperfect substitutes. Yet, the effort isgenerally judged to have failed primarily because thepolicy was not executed vigorously enough.13 Thepoint (as emphasized by Malkiel) is that a central bank

policy of affecting the term structure for interest ratesdepends, for its effectiveness, on two points: thebank’s ability to affect significantly the r’elative supplies

ofshort- and long-term financial assets and its willing-ness to do so. In this case of intervention in domesticasset markets, the extent of the activity was inadequate

to have any significant impact.

Similarly, when sterilized intervention in foreign ex-

change markets is undertaken, the immediate distribu-

13As Johnson (1963), cited in Malkiel, p. 234, concludes:Whatever might have been expected of this policy. . . it was not in factpursued in any effecrive sense. As a result primarily of Treasury fund-ing operations, the maturiry of the debr in r he hands of the public has in

fact been lengthened appreciably, instead of shorlened as the policywould require.

lion of currencies and securities denominated in thosecurrencies is altered; two market activities, however-,are thereby set in motion that tend to undo anyimpact on relative interest rates and the exchange rate.First, private entities — banks, primarily, but also indi-vidual traders — sell or buy securities denominated inthe currencies that have been affected. Second, actualcun-ency flows and options to buy or sell currencies orforward contracts are changed. Thus, unless the cen-

tral bank is prepared to take sufficient actions to altertnarket expectations, it will be unlikely to affect theexchange rates by sterilized intervention.

The Potential: Foreign Asset Holdingsand the Size of the U.S~ForeignExchange Market

The likelihood that intervention can affect exchangerates may be assessed by comparing either private and

700

600

400

200

—Is

1913 1914 1975 1916 1977 1918 1979Saurces, Board af Gaverears

0f the Federat

do nat reflect t977 benchmark revisian.

0

22


Chart 2

Relative Investment Flows into Foreign Assets

Billions of dollors Billions of dollars120 120

80

s20

~-~

~:~

Ne-’

-______ .. / ~

Changes in private U.S.asset holdings abroad a

j ~ge~d~

hoidings in the United Stalesu,~ -

0 -,- —---

U.S. loreign exchangeintervention t2

-----—

~--

1973 1974 1975 1976 1977 1978 1979 1980 1981 1982Sources, Bawd of Gavet-nars of the federal Reserve System and u.s. Deportment of Commerce

central bank for’eign asset holdings or central bankactivity and the size of markets for foreign exchange.

The relevance offoreign asset holdings is that changingany single exchange t-ate changes the price of theseassets in two or’ more currencies. Consequently, ex-

change rate movements caused by intervention may bepresumed to induce shifts in desired portfolios ofassets — that is, flows of asset sales and purchases

that tend to offset such changes.

Chart I shows the stocks of foreign assets held byU.S. individuals and institutions, U.S. assets held byprivate foreigners, and the foreign reserves (minus

gold) of the U.S. Federal Reserve System and the Trea-sury. It is clear that private investors hold a much

lar-ger share of assets traded in international marketsthan do the Fed and the U.S. Treasury. Consequently,

to change the pnce at which these assets are valuedwould require very aggressive intervention.

Many have argued that the primary impact of in-tervention is on the flow demands for the currenciesinvolved. If so, one should compare the flows of trans-actions in these markets rather- than asset holdings.t4

From this perspective, consider chart 2—transactionsin international markets. Comparing the rate of ac-

‘4This leaves aside, for the moment, the indirect effect of interventionthrough changes in expectations offuture central bank policy, whichwill be considered later.

100 100

80

60

40

20

0

-20

U, Annual rate.

[2Pasitive values are purchases of dallars.NOTE, Direct investment data priar to 1977 do not reflect 1977 benchmark revision.

23


\,~ :~c,~J ,~s, ~ ~ t~L‘~ ,

, I 4S , ~ L~’ ~ I~\ ~ ~Lcy <‘~ ‘ ~L /‘ ,~i\‘~‘f”~

~ ~ ttlp~~er ‘IL ~ “ ~ .)~ :: ~ ~ ~~Møø ~ c~~ ~ ~ —:~1& ~~ ~r~c:~ ‘5 ~s ~ ~ ~Jwk~w. ~A$fl~ØL/ >

~ ~ ~ ~ ‘S ,, L5 ,,,/cLv~ ~H ~ ~&, /s.~‘<K ~“P’’ ‘L’ LA “ , ‘\,</~~~/\/\

Ii,,sc /r ~‘ ~ ~ — /4 “ ~ c~ ‘~ ~ ~,, ~‘ 7 <‘~S,Pz ~~~ ./ — ~4k ~ ~ ,, ~/,4. ~

,. C / ,, ~ c.~ ~N C~z .~, L <~ ~‘ & ~s,

,~.‘ ~5~

k .~ 4 ,,~Lt ~ ~ ‘s/ ~ “ ‘/

,~ ~ ~‘ .~ ~4~\ ~ ~ ~ ~, ~, I 4’~~ ‘~‘ r “ ~ ~ ‘7 VC’. ~ k..V.’ ,.t , L’ <VL .,,~\ ‘S. ., ‘. ~ ~ ..VV//\~

~V&V~1

~ ~‘ ,. V V c<:~ <~ ~ /~ ~ Vs ~‘ ‘~ ‘ ~ ~ L~ ,~ ~

~~:rt~~t Tff%~flV1~i~trw ~~~ V

.7,. ~ ~. ~ ~. ,\ V ~ ,~ &V •.u~aL V ~ ‘S~<” ~ ,.~

:1 ; ~ ~ .‘ : V ~ N

/V ~ V V1~lS~$o: ~j~:EIV~ ~rnNItm~~~ V~ ~ Mi

N~:: ~ ~:NV N

:,:~::~~ ‘~ ~ VN>

V~1t~V~ ~: !t~L ~ ~,N

quisition offoreign assets by U.S. investors with the rateofintervention by U.S. monetary authorities (combinedU.S. Treasury and Federal Reserve) clearly demon-strates that the private U.S. investment activity onan annual basis swamps that of the authorities, and,

in fact, so has the rate of purchase of U.S. assets byforeigners in recent years.

Another, perhaps even more relevant. comparisonwould be the transaction rates over intervals shorterthan a year. That is, it might be argued that chart 2shows net figures over an irrelevantly long time period:what matters is the gross volume of transactions in,say, a month or a day. From this perspective, consider

the data in table 1, which r-epor-ts the turnover statistics

for U.S. banks engaging in significant volumes of foreign

currency transactions.55 As the table shows, both thevolume in the observed month) per bank and thenumber of banks with significant involvement in for-eign currency markets have risen dramatically since1977. The total volume has risen sevenfold, comprisinga quadrupling in the per-bank volume indicated bythe changes in the activity of the banks originally sur—veyed in 1977) and a tripling from 44 to 119) of thenumber of banks actively participating in foreign cur-

‘tThe data in the first half of table 1 are from periodic surveys of U.S.banks that engage in significant foreign exchange market transac-tions. These surveys are conducted by the Federal Reserve Bank ofNew York. For more details about these surveys, see Revey (1981).

24


rency markets. If the volume in contracts during April1983 is expressed in a daily aver-age form, the market in

U.S. banks alone is about $33.5 billion. Almost two-thirds of these contracts are spot currency exchanges.

In comparison, the table also reports the combined

Federal Reserve-U.S. Treasury intervention for the fullsix-month period containing each of the three surveydates along with representative episodes of significantUS. intervention. As even a cursory review of the datareveals, U.S. intervention activity has been trivial rela-

tive to the volume of bank trading in currencies; onlyrarely has intervention been morn than a tiny fractionof the private market volume. Consequently, the notionthat the central bank has influenced the market priceof currencies — their exchange rate — purely by affect-ing the flow volume of exchange is inconsistent withthe recent record.

Some Direct Evidence: Report of theWorking Group on ExchangeMarket Intervention

Central bank intervention — whether in domesticasset markets or international currency markets—canbe effective only if the market is convinced that themonetary authority is both able and willing to affect theflows of transactions. In view of the growing size ofprivate currency markets and the conflict with domes-tic inflation policies that effective intervention would

require, such an effect on market expectations alsoseems to be beyond the grasp of the U.S. authorities.

Support for this conclusion is provided by the study

of exchange market intervention conducted by theworking group established at the Versailles Summit inI9sz.~~This report is especially significant since it

represents the most comprehensive analysis of themotives, methods and impacts of central bank inter-vention in foreign exchange markets that has beenconducted using actual intervention data — data un-available to most researcher-s.

While the working gi-oup found that sterilized in-tervention is not totally ineffective, its effect was much

smaller than that of unsterilized intervention.’7 Fur-thermol-e, the group found that intervention could heeffective in the face of persistent mar-ket pr-essures onl

if it was supported by complementary changes in

‘6fleport of the Working Group on Exchange Market Intervention(1983). What follows is a synopsis of the major conclusionsdrawn inthis report.

‘7

Additional support, at least for Germany, is provided by Obstfeld(1983). pp. 184—85, as he concludes that:

domestic policy, especially monetary policy. When in-consistencies have arisen between domestic policyand exchange rate objectives, the group found thatintervention (counter to the goals of domestic policy)was frequently useless and even counterproductive inthe absence of supportive domestic policy. Conse-quently, the ministers, in their statement released withthe working group’s report, downplayed the impor-tance of sterilized intervention as a separate policy

tool:

We have reached agreement [that), under the presenrcircumstances, the role of [sterilizedl intervention canonly be limited. - . - Intervention will normally be usefulonly when complementing and supporting otherpolicies 58

CONCLUSION

Most discussions of the effectiveness of central bankintervention focus on expectations of market partici-pants and how intervention alters them. Yet, even if thecentral bank is capable of altering market expectationsabout its future policies, such a change can be broughtabout only if the market is convinced that other policy

goals — the domestic inflation rate, level of interestrates, stability of domestic credit markets, etc. — aresubordinate to exchange rate manipulation. For theUnited States, at least, such a policy stance would notbe credible. Thus, the efficacy of exchange rate in-tervention would seem to be diminished greatly by thepublic’s knowledge of the primacy of other monetary

policy objectives.19

The model’s verdict was that the Bundesbank has little if any power toinfluence the exchange rare over that lime span [one month] withoutaltering currentor expected future money-market conditions [i.e., with-out conducting unsterilized intervention].

ltStatement on the Report of the Working Group on Exchange MarketIntervention (1983), p. 2.

‘0Consider again the view of former Bundesbank President Em-minger (Bank for International Settlements [1982j. pp. 5—8):

To sum up: Exchange rare policies cover a wide spectrum: trom simply‘having a view’ on the exchange rate to smoothing out disorderlyconditions’ to avoiding excesses which are palpably far out of line withfundamentals and are disturbing. The instruments range from interven-tion to interest rate policy, general monetary and other economicpolicies, and to official borrowing or lending.

There is also a wide spectrum in the use ofsuch policies from country tocountry. This is partly a question of size. For the United States, there isquite certainly no other solution but free floating. The problems of amore active exchange rate policy are mainly relevant br middle-sizedindustrial countries, It is therefore natural and understandable that theattitude lowards exchange rate policy differs between the UnitedStates and other industrial countries.

There is also another important difference, which makes the UnitedStates a special case. Other industrial countries usually lake the dollarus yardstick and intervene against the dollar. For the United States, it ismore difficultto decide against which individual currencies they shouldmeasure the value of their currency, and against which to intervene incase of need. This is one of the several problems on which the oft-requested joint and concerted intervention policy would founder.

25


REFERENCES

Arenson, Karen W. ‘DollarSeen ator Near Peak,” New York Times,February 14, 1984.

Balbach, Anatol B. ‘The Mechanics of Intervention in ExchangeMarkets,” this Review (February 1978), pp. 2—7.

Bank for International Settlements. Press Review (February 18,1982), pp. 2—6.

Bank for International Settlements. Press Review (February 7,1984), pp. 1—5.

Batten, Dallas S., and Mack Ott. Five Common Myths About Float-ing Exchange Rates,” this Review (November 1983), pp. 5—15.

Bergstrand, Jeffrey H. “Is Exchange Rate Volatility Excessive’T’New England Economic Review (September/October 1983), pp.5—14.

Feldstein, Martin. ‘The World Economy Today,” The Economist(June 11, 1983), pp. 43—48.

Johnson, Harry 0. ‘An Overview of Price Levels, Employment, andthe Balance of Payments,” The Journal of Business (July 1963),pp. 279—89.

Kraus, Albert L. “Turn in Dollar’s Value Already May Be at Hand,”New York Journal of Commerce, February 14, 1984.

Kubarych, Roger M. Foreign Exchange Markets in the Unitedrevised edition (Federal Reserve Bank of New York, 1983).

Malkiel, Burton Gordon. The Term Structure of Interest Rates(Princeton University Press, 1966).

Obstfeld, Maurice. ‘Exchange Rates, Inflation, and the SterilizationProblem: Germany, 1975—1981 ,“ European Economic Review(March/April 1983), pp. 161—89.

Report of the Working Group on Exchange Market Intervention estab-lished at theVersailles Summit of the Heads of State and Govern-ment, June 4,5, and 6, 1982 (March 1983).

Revey, Patricia A. ‘Evolution and Growth of the United States For-eign Exchange Market,” Federal Reserve Bank of New YorkQuarterly Review (Autumn 1981), pp. 32—44.

26

What Can Central Banks Do About the Value of the …...What Can Central Banks Do About the Value of...

Documents

Transcript of What Can Central Banks Do About the Value of the …...What Can Central Banks Do About the Value of...