V Foreign Exchange Market Intervention in Inflation-Targeting Policy Implementation
- Anna Nordstrom, Scott Roger, Mark Stone, Seiichi Shimizu, Turgut Kisinbay, and Jorge Restrepo
- Published Date:
- November 2009
This section documents the role of foreign exchange market intervention in inflation-targeting policy implementation and makes some positive recommendations for inflation-targeting emerging economies. The previous section made the case that taking the exchange rate into account in the monetary policy rule can improve the macroeconomic performance of inflation-targeting emerging economies under certain circumstances. However, although appropriate macroeconomic circumstances are a necessary condition for a fully effective role for the exchange rate, they are not sufficient.
A strong policy implementation framework is also required, especially to ensure that an active role for the exchange rate does not lead to confusion about the commitment of the central bank to the inflation target. If the central bank decision-making process is not fully integrated, the result may be that foreign exchange interventions are not coordinated with domestic monetary operations. Low operational transparency may lead markets to question whether a change in the policy interest rate or a foreign exchange market intervention is aimed at supporting the inflation target or only at managing the exchange rate itself. With undeveloped financial markets, foreign exchange intervention operates primarily through the portfolio balance channel, which is relatively unpredictable, rather than through the signaling channel, which fits much better with inflation targeting.
However, establishing a strong policy implementation framework can be especially challenging for inflation-targeting emerging economies. The conditions for transparency are not as favorable for them, and they have shorter inflation-targeting track records. Further, many have a history of managed or fixed exchange rate arrangements and active exchange rate intervention, which can raise questions about whether the exchange rate is subordinate to the inflation target.
Foreign exchange intervention is stressed in this section because it is the main exchange rate policy implementation tool. Generally, the monetary and exchange rate policy implementation framework covers the intermediate target, the operating target and monetary instruments, the modalities of transparency and accountability, and the institutional practices of the central bank. The objectives of foreign exchange intervention are described in Box 5.1, and Box 5.2 summarizes foreign exchange intervention in emerging economies.
Foreign exchange intervention under inflation targeting is not amenable to macroeconomic modeling, and so this chapter is largely based on case studies. Macroeconomic models are not well suited to assessing policy implementation for several reasons. First, there seem to be no models rich enough to incorporate both an interest rate instrument and foreign exchange market intervention. The challenge of explicitly modeling the channels of foreign exchange intervention is especially formidable. Second, there has been limited analysis of the impact of market development or the trade-offs posed by a transparent policy role for the exchange rate. Third, macroeconomic models are typically parameterized at a quarterly frequency and thus cannot capture intervention for daily or weekly exchange rate smoothing. Therefore, foreign exchange market intervention is addressed qualitatively here, based primarily on the case studies (Sections IX and X) and the implementation literature, although other sources are used as well.
This section is organized according to the role of the exchange rate under the inflation-targeting taxonomy outlined in the previous section. This is because the different approaches broadly correspond to implementation frameworks. Furthermore, effective implementation frameworks are those that are tailored to the levels of market and infrastructure development, which are shaped by the same factors that explain different policy approaches. The assessment of policy implementation under inflation targeting focuses in particular on market friendliness and transparency. Policy implementation under inflation targeting tends to be market based and market supporting given the role of money markets in monetary operations and the importance of asset markets for monetary transmission. Targets and instruments under inflation targeting are typically as transparent as feasible because an inflation-guided policy is inherently forward looking, and making policymakers’ views and intentions transparent fosters signaling and ex post accountability. Exchange rate implementation is usually relatively less transparent than other aspects of monetary policy (Box 5.3). The discussion of foreign exchange intervention transparency is discussed here in terms of (1) disclosure of the objectives of intervention; (2) disclosure of the procedures for intervention such as the central bank’s counterparties, the instruments and terms, and the reporting of intervention operations on an ongoing basis; and (3) disclosure of quantitative and qualitative information on intervention operations, sometimes with a considerable lag.
Box 5.1.Foreign Exchange Intervention: Matching Objectives and Practices
There are five purposes for foreign exchange intervention.
- To directly affect the exchange rate for policy purposes: The most common reason for intervening in the foreign exchange market is to maintain some form of exchange rate peg or, under a float, to address exchange rate misalignment, reduce the speed of appreciation or depreciation, or support financial stability. These goals usually involve different implementation techniques, and the way a central bank conducts its foreign exchange interventions can help reveal its goals and whether these are consistent with the ultimate objectives of monetary policy. For example, interventions to address exchange rate misalignment tend to be less frequent but more sizable.
- To smooth foreign exchange market conditions: Smoothing excess volatility normally produces more frequent and smaller transactions, often in both directions.
- To manage international reserves: Interventions to manage international reserves are usually guided by principles of transparency and predictability and are normally designed to minimize the exchange rate impact. Ambiguity in the implementation of these transactions carries the risk of making their use seem like an intervention tool. Many countries choose to make these interventions through announced auctions (Turkey and Mexico) rather than through discretionary transactions, in order to minimize the potential impact on the exchange rate. Central banks also seek to time these transactions so as to minimize the exchange rate impact. For example, foreign exchange reserves would normally be accumulated when there are strong capital inflows. Even for discretionary operations, the timing would normally be announced.
- To conduct official transactions: Many central banks conduct foreign exchange transactions on behalf of the government or directly as a counterparty to other public sector entities, such as state-owned enterprises. The type and extent of official foreign exchange flows managed by the central bank vary among countries. In developed economies, the most common transactions relate to managing foreign-currency-denominated debt or other government receipts and payments in foreign currency. In emerging economies, the central bank may also be the only foreign exchange agent for state-owned enterprises. In Mexico, for example, the central bank is the counterparty to the state-owned oil company Pemex. Initially, these foreign exchange inflows were used to service external debt and to increase official reserves, but they have recently been partly resold into the interbank market to slow the pace of reserve accumulation. To prevent confusion about the objectives of these transactions, and therefore reduce the risk of policy confusion, the central bank resells a fixed amount of foreign exchange through daily auctions.
- To develop markets: Central banks may participate in the foreign exchange market to promote development of an interbank market. The central bank may take on the role of temporary market maker to create more confidence in the interbank market. In such cases, the central bank should be a market maker of last resort and should have a well-developed exit policy so that it does not remain a market maker longer than necessary. In other cases, the lack of a deep and liquid market may require the central bank to clear market imbalances due to lumpy foreign exchange flows, the domination of a single export commodity, or an interbank market structure that is dominated by a few large banks. This is the case in Azerbaijan, where a few players dominate foreign exchange flows, which are related to a single export commodity. In Serbia, the central bank discontinued fixing sessions to develop the interbank market but retains the right to participate for market stabilization purposes.
Plain Vanilla Inflation Targeting
Plain vanilla inflation targeting serves as a natural point of departure because the exchange rate plays a relatively limited role in its implementation.39 The clear commitment of plain vanilla inflation-targeting economies to a single nominal anchor is made possible by their high degree of policy credibility. Under this regime, a short-term policy interest rate serves as the operating target and is adjusted to influence an intermediate inflation target and, ultimately, to maintain price stability. The policy interest rate works through its impact on liquidity and on other interest rates and as a signal that bears on expectations. Repos are usually used to set the interest rate operating target. Inflation targeting is quite transparent compared to other regimes (see Table 3.3 in Roger and Stone, 2005) in facilitating accountability by the central bank. Exchange rate developments are generally not explicitly factored into plain vanilla inflation-targeting policy implementation, although exchange rate developments are implicitly incorporated through their impact on inflation forecasts and on output. Because almost all of the inflation-targeting advanced economies (see Box 2.1) can be viewed as practicing plain vanilla inflation targeting, summary information for this group is used to gauge foreign exchange market intervention practices under this regime, although a few emerging economies also practice plain vanilla inflation targeting.
Box 5.2.Foreign Exchange Intervention in Emerging Economies
The general literature on foreign exchange intervention in emerging economies is limited, reflecting the lack of data, and the results are mixed regarding its effectiveness. In a large cross-country study, Lall and others (2007) concluded that resisting nominal exchange rate appreciation through sterilized intervention is likely to be ineffective when capital flows are persistent. Guimarães and Karacadag (2004) find that intervention tends to increase exchange rate volatility for Mexico and Turkey. Disyatat and Galati (2005) find weak evidence that intervention is effective in the Czech Republic. Kramer, Poirson, and Prasad (2008) analyze recent intervention by five large Asian emerging market economies and find modest evidence that sterilized intervention dampens volatility.
Sterilized intervention generally operates through three main channels, which seem to work differently for emerging economies. Unsterilized interventions are effectively equivalent to open market operations and thus work through conventional monetary policy channels. The three channels for sterilized intervention are the following:
- The signaling or expectations channel affects the exchange rate through a change in market expectations about future fundamentals. The assumption is that central banks have more information about relevant fundamentals and can influence the exchange rate by signaling through intervention. In particular, if intervention signals a change in monetary policy, it is expected to affect the exchange rate through the change in expectations about future interest rates. The signaling channel may be weaker in most emerging economies because central banks have a shorter track record and relatively less credibility (see, for example, Domac and Mendoza, 2002, for Mexico and Turkey). Thus, effective signaling for emerging markets may require larger interventions (Canales-Kriljenko, Guimaraes, and Karacadag, 2003).
- The portfolio balance channel works when a change in the relative supply of domestic versus foreign currency assets causes a portfolio reallocation that changes the relative price of the two assets. This requires that domestic and foreign assets be imperfect substitutes so that a change in the relative supply triggers an increase in the expected return for holding one rather than the other. In deep and liquid foreign exchange markets, economic theory argues that the effectiveness of this channel is less obvious because the intervention capacity of central banks is too small compared with the size of domestic and foreign assets. Dominguez and Frankel (1993) and Sarno and Taylor (2001) are more open to the general possibility that the portfolio balance channel is effective in affecting the exchange rate in larger markets. Galati and Melick (2002) point out that the portfolio balance channel is potentially more effective in smaller, less developed financial markets where the possible scale of central bank intervention is comparatively large.
- The order flow channel reflects how order flows affect price formation. Detailed order flows seem to better predict prices than news releases on conventional fundamentals (Evans and Lyons, 2002). Furthermore, the price impact of financial institutions’ order flows is stronger vis-à-vis the orders of nonfinancial institutions. Under this channel, the size of the intervention relative to market turnover is an important determinant of its effectiveness, which suggests that this channel may be more effective in emerging economies where markets are less liquid. Emerging economy central banks could potentially alter order flows through intervention, because they have access to market information not available to other participants, including from reporting requirements, especially if the market is relatively thin. Scalia (2004) finds a significant impact from order flows on the exchange rate using Czech data. Azañero Saona (2003) provides supporting evidence for Peru.
Inflation-targeting advanced economies intervene infrequently and usually to signal that the exchange rate is misaligned or to smooth short-term volatility. Only two inflation-targeting advanced economies intervene monthly or more (see Table 2.1). Intervention to influence exchange rate misalignment often operates through the signal channel (Australia, Chile, New Zealand), sometimes with the volatility condition associated with exchange rate misalignment. Sweden is a bit different in that foreign exchange intervention may be used to signal monetary policy, with interest rate changes consistent with the direction of monetary policy in the aftermath of an intervention episode. A majority of inflation-targeting advanced economies sterilize foreign exchange interventions, a reflection of the important signaling role of the operating interest rate (see Table 2.1).
Intervention and the role of the exchange rate is naturally more transparent under plain vanilla inflation targeting. The inflation-targeting advanced economies have clearly stated goals for intervention and are transparent (announcing actions after the fact, reporting reserves often, and in some cases announcing intervention in advance or while it is under way). Indeed, the Central Bank of Chile considers its transparency and clear rules as means to help ensure that foreign exchange interventions become an exceptional tool. The clear communication by the Central Bank of Iceland about its concern over exchange rate and economic developments in 2006 may have facilitated subsequent adjustment.
Box 5.3.Transparency of Foreign Exchange Intervention
In 1999, the IMF Interim Committee adopted the Code of Good Practices on Transparency in Monetary and Financial Policies: Declaration of Principles. Case studies of implementation of the code in 16 IMF member countries (Camilleri, Nyawata, and Stone, 2005) indicate that foreign exchange intervention practices are less transparent than domestic monetary operations and that this mainly reflects uncertainty. Too much transparency is thought to trigger a market response leading to foreign exchange market instability, and an element of surprise is needed for an intervention to be effective. On the other hand, too little transparency is seen to cause confusion regarding the commitment to a flexible exchange rate. Transparency about the way interventions have been carried out is widely seen as beneficial.
In a survey of 10 advanced economy central banks, Chiu (2003) finds a large degree of variation in central banks’ disclosure practices, even among those with the same exchange rate regime. The survey participants also stressed the role of uncertainty. Furthermore, Chiu concludes, ex post disclosure of actual intervention operations improves policy effectiveness, as does greater clarity of the objectives of foreign exchange intervention, whereas intervention tactics can perhaps be constructively kept obscure, especially in floating exchange rate regimes.
Many of the reasons given to explain reduced transparency of foreign exchange interventions seem to be especially germane to emerging economies. Dominguez and Frankel (1993) argue that central banks may not want to disclose information on intervention resulting from political pressure because this would undermine policy credibility. They also posit that central banks may want to create a sense of broad two-way trades in markets dominated by one-way bets.
Developed financial markets help make possible the relatively limited policy implementation role of the exchange rate for plain vanilla inflation-targeting countries (see Table 3.1). Deep money markets allow use of an interest rate operating target for signaling and provide the means for sterilization, thus enhancing policy predictability. Developed foreign exchange markets also reduce destabilizing exchange rate movements and provide hedging instruments, thus reducing the need for a policy response to exchange rate pressures.
Open-Economy Inflation Targeting
Open-economy inflation-targeting countries actively respond to exchange rate movements. Most of the inflation-targeting emerging economies use an open-economy inflation-targeting regime, and so the description of policy implementation practices under this regime draws on their experience. The policy interest rate is the primary means by which monetary policy influences inflation, as it is for inflation-targeting advanced economies. However, inflation-targeting emerging economies have less flexible exchange rate arrangements than their advanced economy counterparts (see Table 2.1). In addition, they intervene relatively frequently, usually to manage excess volatility or to promote financial stability. Their intervention objectives include smoothing excess volatility (Brazil, Colombia) and maintaining financial stability (Peru) in dollarized economies. The higher frequency of intervention may reflect a strong portfolio balance channel in the context of thinner foreign exchange markets than in inflation-targeting advanced economies. It may also reflect the signal channel.
Inflation-targeting emerging economies’ foreign exchange intervention is generally less transparent than in inflation-targeting advanced economies (see Table 2.1). Frequent intervention and the absence of clear, transparent implementation frameworks can make it more difficult for markets and the public to assess whether excess volatility or the level of the exchange rate is the focus of intervention. What is considered excess volatility is usually not defined, and the intervention pattern is not always consistent with volatility developments.
The conflicts that can arise from the more active role of the exchange rate for open-economy inflation-targeting economies can be alleviated to some extent by well-designed implementation frameworks. In particular, developed financial markets and greater transparency positively feed back into the policy framework by allowing the central bank to put less weight on the exchange rate and more on the inflation target.
Deeper foreign exchange and domestic money markets enhance policy implementation by reducing exchange rate volatility, facilitating foreign exchange risk transfer, and better signaling policy intentions. Deeper markets may make the portfolio balance channel less effective, but at the same time, they strengthen the signaling channel. There should be a common strategy for foreign exchange and money market development in order to exploit the many synergies (Ferhani and others, 2009). The move toward more market-based monetary and debt-management frameworks played an important role in the development of foreign exchange hedging markets in the Czech Republic and Poland. In Turkey, the development of foreign exchange risk-management instruments to help market participants manage exchange rate volatility may help the central bank limit intervention. The lack of a yield curve initially slowed the introduction of foreign exchange derivatives in Serbia.
The recent spate of foreign exchange liquidity-easing measures undertaken by emerging economies highlights the thin line that sometimes exists between macroeconomic and lender-of-last-resort (LOLR) objectives. As discussed in Section VII, most of these economies took nonmarket measures to ease the acute foreign exchange pressures during fall 2008 (Stone and others, 2008). A sharp increase in the demand for foreign exchange can be met simply by the sale of central bank foreign reserves into the foreign exchange market, with the market distributing liquidity to the institutions that need it most. However, in the event of a market breakdown, reflecting asymmetric information, the central bank may be better off providing liquidity directly to key institutions that are important for overall economic activity (Calvo, 2005). However, LOLR provision of foreign exchange is problematic because the absence of a legal central bank monopoly requires that foreign exchange must come in the first instance from a sale of international reserves, which shrinks reserve money. Sterilization through a simultaneous injection of domestic liquidity may be limited by the potential for currency switching and capital outflow.
Transparency about the role of the exchange rate—objectives, procedures, and evaluation—brings important advantages to open-economy inflation-targeting countries. A central bank can explicitly communicate that foreign exchange intervention aimed at influencing the exchange rate is separate from domestic monetary operations intended to steer expected inflation, including by conducting sterilization separately from foreign exchange intervention. This can shield the central bank from outside pressure to depreciate when appreciation raises concern about competitiveness.
Transparency also facilitates the signaling channel, particularly when central banks communicate the purpose for intervention unrelated to monetary policy (such as reserve management, fiscal agent transactions, and foreign exchange market development). Disclosure of quantitative and qualitative information about intervention operations fosters accountability by the central bank to the inflation target, with limited risk.
Of course, there are limits to the extent of transparency for foreign exchange implementation. Real-time reporting of intervention operations during periods of high uncertainty, and in the context of relatively thin markets, can lead to speculative behavior that can contribute to exchange rate volatility and can compel the central bank to react to market expectations, either to validate or counteract them. Another caveat is that balance sheet vulnerabilities may pose a trade-off between being clear about the commitment to the inflation target and support for financial stability. An announcement by the central bank that it is intervening to limit exchange rate depreciation to reduce risks arising from balance sheet currency mismatches could cause a speculative attack. Thus, significant balance sheet mismatches may mitigate against transparency with respect to pending intervention and ongoing operations.
The central banks of Colombia and Mexico have used mechanisms to accumulate reserves that limit the impact of reserve purchases and sales on the foreign exchange market; without these, markets could interpret such transactions as aimed at managing the exchange rate. Turkey, under normal circumstances, limits intervention to predictable daily foreign exchange purchase auctions of small amounts, in order to build up reserves.
Inflation Targeting with Exchange Rate Bands
Exchange rate objectives and foreign exchange intervention interact closely in inflation-targeting economies with an exchange rate band. Policy implementation is basically the same as in plain vanilla inflation-targeting countries, except that the explicit exchange rate constraint on policy can sometimes necessitate a policy response. Chile, Israel, and Poland employed an exchange rate band during their transition to inflation targeting. The two most recent practitioners of this regime, Hungary and the Slovak Republic, are prospective entrants to the euro area.40 The interest rate is their main instrument to implement the inflation target and to maintain the exchange rate band.
Conflicts between meeting those two goals is the unique policy challenge for those countries following this regime. Chile, Israel, and Poland used an exchange rate band to help stabilize expectations but at times had to widen the band in response to shocks. Of course, the wider the band, the less effective it is as a stabilizer. The ERM II countries have a somewhat different reason for employing a band, and they enjoy a relatively high degree of credibility, but a sudden shift in investor sentiment leading to an appreciation can compel a decrease in interest rates that can result in a breach of the inflation target. The Slovak Republic occasionally intervenes to counter exchange rate pressures, and in March 2007, it revalued the central parity rate. In Hungary, speculative attacks on the exchange rate triggered interventions and a widening of the band, and, ultimately, led to abandonment of the band.
Country experience suggests that the policy goal should be to keep the exchange rate in the middle of the band. The central parity rate may need to be adjusted if fundamentals move the exchange rate toward one edge of the band. Furthermore, under most circumstances, exchange rate intervention should be used primarily to offset temporary shocks that move the exchange rate to the edge of the band, with the interest rate used as the operating target otherwise.
The inherent conflict between implementing the inflation target and maintaining the exchange rate band poses some difficult issues for transparency. Obviously, transparency about the objectives of exchange rate policy is crucial under this regime to assure markets that the central bank is committed to the band. However, procedural and ongoing operational transparency may be less appropriate when central bank intervention is required to keep the exchange rate in the middle of the band and may attract speculation (Enoch, 1998). In fact, explicit statements about where the exchange rate should be within the band can trigger speculation, as in Hungary.
Exchange-Rate-Based Inflation Targeting
In exchange-rate-based inflation targeting, monetary policy implementation is centered on the exchange rate. Singapore manages a trade-weighted exchange rate within an undisclosed target band, with the primary objective of maintaining low inflation.41 The Monetary Authority of Singapore (MAS) intervenes to keep the exchange rate within the band. The interest rate is not used as either an operating target or a signaling tool, unlike under other regimes. Money market operations are largely neutral with respect to domestic interest rates, and thus under normal circumstances, foreign exchange intervention can be said to be sterilized in a broader sense. There have been a few occasions when the MAS left its intervention unsterilized in an attempt to thwart speculative pressure.
Singapore has increased transparency in recent years about how policy is formulated (Khor, Robinson, and Lee, 2004). The MAS reports on how macroeconomic developments feed into the formulation of policy, including through publication of semiannual monetary policy statements.
However, exchange-rate-based inflation targeting may be naturally less transparent than the other regimes. Unlike under regimes with short-term interest rate operating targets, policy decisions may affect the viability of current exchange rate targets, given the potential for large gains from exchange rate arbitrage. This suggests that authorities will be under pressure to adjust the target once markets clearly expect such a change, particularly when there is substantial capital mobility. It also suggests that it may be difficult to clearly announce information regarding the current target, the frequency of target changes, and the rationale behind such changes.