Are central bank interventions in Foreign Exchange markets effective?

The Foreign Exchange (FX) market is the largest financial market in the world by volume. With FX reserves of central banks at some of their highest levels in recent history, survey evidence suggests that central bankers generally regard FX intervention as a very useful policy tool for a variety of aims, such as limiting FX volatility.

Are they right to hold this view? Academics have tended to be sceptical on the matter. So with this in mind, the researchers for the paper When is Foreign Exchange Intervention Effective? Evidence from 33 Countries set out to examine the effectiveness of FX intervention in a systematic fashion. The paper focuses on a broad cross-section of countries in order to draw general lessons and detect what determines effective FX interventions.

Where other studies have been restricted in their access to data, this study was uniquely able to draw on daily intervention data from 33 central banks, 23 of which do not make their figures publicly available.

Thanks to the broad coverage of the sample, the study provides a more representative picture about intervention characteristics than is common in the literature. It found that the sampled central banks intervened, on average, 19.1 percent of the trading days in the dataset of 114,000. Observations suggest that the policy of intervention is widely and commonly used. Indeed, all central banks in the sample intervene over the period from 1995 to 2011, irrespective of their exchange rate regime. Although major central banks such as the Federal Reserve and the European Central Bank rarely intervene, those in emerging and developing countries were found to intervene frequently.

The effectiveness of interventions was then tested by the application of a standard event study approach. Three measures of effectiveness were used:

• The ‘event criterion’ – the ability of intervention to change the direction of the exchange rate;
• The ‘smoothing criterion’ – the ability of intervention to smooth the path of the exchange rate, and;
• The ‘stabilisation criterion’ – the ability of intervention to stablise the exchange rate and keep it in a narrow band.

These criteria capture different aspects of intervention effectiveness that are not necessarily correlated, and the paper takes into account varying exchange rate regimes in its analysis.

Based on these criteria, the research finds clear evidence that FX intervention is an effective policy tool. This holds particularly true when interventions are large in size and accompanied by appropriate communication during periods of market turmoil.

Overall, given the general difficulty of influencing financial markets, the evidence reported in this paper indicates that authorities around the world have grasped the art of FX intervention better than had been supposed. This analysis therefore should be of great interest to policy makers.

The accepted version of the paper is available for download at the link below. The final paper was published in American Economic Journal: Macroeconomics

A more detailed summary of the paper is available at VoxEU - Foreign Exchange Interventions: Frequent and effective