Currency intervention – Is it possible?

Whenever there are large sustained moves in currency markets, there are macroeconomic winners and losers. The losers, usually those with strong appreciation, will see declines in exports and GDP drag. The losers will start to contemplate the use of central bank intervention directly in the foreign exchange markets to arrest the change in currency levels, so it is natural to hear the current discussion about intervention to stop the dollar decline. Nevertheless, it is unlikely at this time given the underlying economics and political environment.

What academic research has shown is that first, uncoordinated intervention will not have a long-term impact on foreign exchange markets. Second, intervention without a change in underlying monetary policy is unlikely to have a strong effect. There have been periods of coordinated intervention and these have had an impact in reducing or changing the direction of exchange rates, but the number of cases over the period of flexible exchange rates is limited. The coordinated events include:
1. The Plaza Accord – 1985; push dollar lower.
2. The Louvre Accord – 1987; push the dollar higher.
3. Yen reaction – 1995; halt dollar decline.
4. Yen support – 1998; halt yen decline.
5. G7 Euro support -2000; halt Euro decline.

Intervention has been used to smooth exchange rates or reduce volatility. In general, these actions have been ineffective at changing the direction. In fact, trend-followers usually do better during these periods of volatility smoothing because the noise in the price trend is reduced.

The current dollar decline is actually quite consistent with the economics across countries. The dollar decline has matched the change in interest rate differentials with many countries. With interest rates actually higher in Europe, it should not be surprising to see a dollar decline if you believe in a carry story. For the case of Japan, even with the highest inflation in over a decade, the real rate in Japan is higher than what we are seeing in the United States. Monetary policy is looser in the United States relative to many other countries which is dollar negative. The growth prospects in the United States are also lower which is dollar negative. This is without even considering the credit risk issues concerning US investments associated with the mortgage crisis. All of this suggests that the direction of the dollar is consistent with theory.

On the political side, the general belief by most governments is currencies should be allowed to operate as a competitive market except if there is excessive volatility. The dollar, by the volatility standard, does not fit the criteria. There also does not seem to be much concern about the dollar decline in the US government. The Bush government has not made any comments that would suggest that there is a concern about the dollar. There is also a desire by the US government for a lower dollar to help exports and the current account deficit. While the ECB has commented that it is “concerned” about the dollar decline, Euroland monetary policy is hawkish and out of step with the US which has been on a course of rapid rate declines. They want to maintain the current policy which facilitates a strong euro. Without a head of the Bank of Japan, there is less likelihood of strong yen leadership for a decline.

Finally, there is still the issue of the relationship between China and the G7. The overarching issue of global imbalances has been for a Yuan appreciation and a dollar decline. We are seeing the adjustment of the global imbalances, so it would be hard to now have the G7 state that the dollar decline has gone too far when the global imbalance issue still exists. Currency coordination cannot occur without some of the large surplus countries involved in the process, and we do not seem to have an intervention consensus.