Profit-maximizing central bank behavior ?

Central banks have not been traditionally viewed as profit maximizers. This belief has been backed up with research that showed central banks losing money on their adjustments of foreign exchange reserves. Of course, foreign exchange trades were used as a policy instrument to stabilize exchange rates. Central banks would lean against the wind when fundamentals were pushing exchange rates away from the direction desired by the monetary authorities. Intervention has fallen dramatically in recent years.

Behavior has changed. A story in the Financial Times states that Japan is interested in creating an investment arm to actively manage their foreign exchange reserves, (http://www.ft.com/cms/s/c6be88e0-f0f7-11db-838b-000b5df10621.html). This is following in the footsteps of China which also recently announced an interest in starting an investment arm. A number of government authorities have become active at managing their reserves including Singapore and the Scandinavian countries.

This activity make sense for any individual central bank, but when the amount traded gets larger as all central banks jump into the trading game the ramifications on the FX markets will be huge. The "alpha" from FX trading could be substantially squeezed. More importantly, central bank flows, in an effort to seek higher returns, may create price activity significantly different than what has been seen in the market. Trading activity may lead to periods of dampened volatility if the activity is counter to trends in private flows. It can also reinforce markets movement and increase volatility if the strategy of the bank is to be a momentum player. A change in the competitive mix of buyers and sellers may reduce liquidity and spillover to other asset markets. The profit objectives for central banks may be very different than private investors.

While the IMF and central banks have been arguing for more information on the behavior of hedge funds, they may actually want to focus closer to home. Central bank trading activity attempting to generate profits could more than swamp hedge fund trading. Who will police the activities of central bank trading?