On the long-term effectiveness of exchange rate communication and interventions
Introduction
Communication and foreign exchange market interventions are two policy tools available to monetary authorities to influence exchange rates. The past decade has been characterised by remarkable differences in the approaches monetary authorities around the world have taken towards influencing exchange rate movements. Some monetary authorities, such as those in Japan, have periodically conducted substantial purchases or sales in foreign exchange markets, often supported by exchange rate communication, or oral interventions. Others, such as the US and euro area authorities, have taken a different route by basically abandoning direct market interventions and relying on communication as their primary policy tool to affect exchange rates.
How successful have monetary authorities been with their use of these policy instruments in influencing exchange rates? The literature on FX market, or actual interventions has found mixed and partly supportive evidence that purchase and sales of foreign exchange may help move currencies in the desired direction (e.g. Edison, 1993, Sarno and Taylor, 2001). More recently, policy-makers (Rubin and Weisberg, 2003) have argued and academic research (e.g. Jansen and de Haan, 2005, Fratzscher, 2004) has found that communication may have a significant impact on exchange rates. This literature on the role of communication is still in its infancy but constitutes a first step towards understanding the appropriate policy design by monetary authorities.
Two important questions arise from the literature on communication and actual interventions that so far have not been answered conclusively. First, through which channels do communication and actual interventions affect exchange rate developments? From a conceptual perspective, interventions may affect exchange rates through three alternative channels. In the portfolio balance channel, an actual purchase or sale of foreign exchange by a monetary authority alters the relative supply and demand of domestic versus foreign assets, thus altering the exchange rate even if these interventions are sterilised due to imperfect substitutability of the underlying assets (e.g. Dominguez and Frankel, 1993). Under the signalling channel, actual or oral interventions may be perceived by markets as indicating future monetary policy or developments of other policy measures (Mussa, 1981, Lewis, 1995, Kaminsky and Lewis, 1996, Bonser-Neal et al., 1998). Moreover, exchange rate communication may be understood by market participants to raise the likelihood of future actual interventions, thus inducing an anticipating reaction of foreign exchange markets. Both of these channels, however, imply that interventions should have only a one-off and immediate effect on exchange rates if markets are efficient and incorporate all relevant information immediately.
But taking a market microstructure perspective, based on the work by Evans and Lyons (2002) and Peiers (1997), interventions may influence exchange rates also by functioning as a co-ordination device for market participants, or what has been referred to as a co-ordination channel (Sarno and Taylor, 2001). Under this channel, by functioning as a co-ordination device for investors, actual and oral interventions may alter the dynamics of foreign exchange markets, implying dynamic and long-term effects on exchange rates. Evans and Lyons (2005) provide compelling evidence for a gradual incorporation of macroeconomic news into prices that takes several days. They relate this gradual absorption to the trading taking place between end-users, such as by hedge funds and mutual funds, and explain it through the fact that trading itself provides relevant information to market participants. This result is also consistent with the results of Andersen et al. (2003), who find that volatility effects of news often rise over time initially and are overall quite persistent.
The question of key policy relevance is precisely how permanent and long-lasting the effects of oral and actual interventions are. The objective of this paper is to address this question empirically, first, by analyzing the strategy of communication by G3 monetary authorities, and second, by assessing the long-run effectiveness of communication and actual interventions for G3 economies since 1990. The paper starts by outlining how exchange rate communication is measured and classified, using reports issued by the newswire service Reuters News. While any measurement and classification of communication is prone to be incomplete and to reflect imprecisely the intentions of policy-makers, the aim is to take a financial market perspective and to understand how market participants react to news that becomes available to them, in particular exchange rate communication.
Concerning the long-term effectiveness, communication, and to some extent also actual interventions are found to have a significant contemporaneous impact on G3 exchange rates on the days when these interventions take place. However, using cumulated impulse responses obtained from an EGARCH model specification shows that the effect of oral and actual interventions cannot be shown to be statistically significant beyond 2 or 3 days. The paper argues that this finding cannot be interpreted as evidence against long-term effectiveness of interventions, but only implies that the effect of individual interventions is not sufficiently large to dominate all other factors that influence exchange rates. In fact, I show that also the impact of important macroeconomic news, such as announcements of US non-farm payroll employment and of the German Ifo business confidence index, is not statistically significant beyond a few days.
To gauge the longer-term effectiveness of communication and actual interventions, the final part of the paper turns to forward-looking indicators of exchange rates, in particular implied volatilities, risk reversals and strangles obtained from over-the-counter (OTC) option contracts. Two key results emerge. First, exchange rate communication in particular has a statistically significant effect on forward rates for a horizon up to 6 months, whereas actual interventions by most authorities have a significant effect on forward contracts only over a shorter horizon. Second, a fundamental difference between communication and actual interventions exists for their impact on volatility. Communication mostly reduces historical volatility of spot rates, based on the EGARCH specification, as well as the implied volatility of OTC option contracts, whereas actual interventions mostly increase both types of volatility. This underlines a key difference between communication and actual interventions and may be explained by the different ways in which they are conducted, with actual interventions often being carried out in secret, thus inducing a significant degree of uncertainty among market participants about whether such interventions took place, how large they were and whether they are part of longer series of interventions. By contrast, communication provides a public signal and information available to all participants, thus possibly reducing the heterogeneity of information and beliefs and helping reduce volatility.
The paper is structured in the following way. Section 2 provides a short review of the literature on exchange rate communication and actual interventions, while Section 3 introduces the data, in particular also discussing some of the caveats underlying the measurement of the communications data. Section 4 presents the empirical results on the long-term effectiveness of interventions based on an EGARCH model for spot rates as well as for option contracts. Section 5 concludes.
Section snippets
Transmission channels and time consistency of interventions
How do actual and oral interventions work and how are they used? In principle, the literature has focused on three broad channels: the portfolio balance channel, the signalling channel and a co-ordination channel.
In the portfolio balance channel, actual foreign exchange interventions – both when sterilised and when non-sterilised – alter the relative supply of domestic and foreign financial assets. This induces a change in the price of these assets, thereby affecting a change in the relative
The data: communication and actual interventions
The starting point is to present the data on oral and actual interventions by the monetary authorities of the United States, Japan and the euro area, and to discuss some of the caveats.
With regard to exchange rate communication, the first issue is how to measure such communication. In principle, one would like to obtain a complete list of all statements in which policy-makers express a view about the domestic exchange rate. Since the objective of the paper is to measure whether such
Long-term effectiveness of interventions
Do communication and actual interventions move exchange rates? And if so, does this imply that the oral and actual interventions have a long-term effect? This section addresses this issue by analyzing the contemporaneous and dynamic effects of interventions in an EGARCH framework, first for the spot exchange rate, and then by using forward-looking exchange rate indicators based on OTC option contracts and other asset prices.
Conclusions
Communication and actual interventions are two direct policy tools monetary authorities have to influence exchange rate developments. Over the past two decades monetary authorities have adopted very different approaches in using these policy tools. Several authorities, in particular those in the United States and in the euro area, have basically abandoned the use of actual purchases and sales in FX markets in the mid-1990s and have used almost exclusively communication to alter exchange rate
Acknowledgements
I would like to thank Terhi Jokipii for excellent research assistance. Comments and suggestions from seminar participants at the European Central Bank and at the JIMF–CRIF–TAFI conference on “Foreign Exchange Markets”, in particular Michael Melvin, are gratefully acknowledged. The views expressed in this paper are those of the author and do not necessarily reflect those of the European Central Bank.
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