As in some other major industrial nations with floating exchange rate regimes, in the United States there is considerable scope for the play of market forces in determining the dollar exchange rate. But also, as in other countries,U.S. authorities do take steps at times to influence the exchange rate, via policy measures and direct intervention in the foreign exchange market to buy or sell foreign currencies. As noted above, in practice, all foreign exchange market intervention of the U.S. authorities is routinely sterilized—that is, the initial effect on U.S. bank reserves is offset by monetary policy action.
No one questions that monetary policy measures can influence the exchange rate by affecting the relative attractiveness of a currency and expectations of its prospects, although it is difficult to find a stable and significant relationship that would yield a predictable, precise response. But the question of the effectiveness of sterilized intervention, which has been extensively studied and debated, is much more controversial. Some economists contend that sterilized intervention can have, at best, a modest and temporary effect. Others say it can have a more significant effect by changing expectations about policy and helping to guide the market. Still others believe that the effect depends on the particular market conditions and the intervention strategy of each situation.
Given the present size of U.S. monetary aggregates, balance of payments flows, and the levels of activity in the foreign exchange market and other financial markets, it is widely accepted that any effects of sterilized intervention are likely to be through indirect channels rather than through direct impact on these large aggregates. Empirical tests of sterilized intervention have focused on two main channels through which such intervention might indirectly influence the exchange rate: the portfolio balance channel and the expectations, or signaling, channel..
The portfolio balance channel postulates that the exchange rate is determined by the balance of supply and demand for available stocks of financial assets held by the private sector. It holds that sterilized intervention will alter the currency composition of assets available to the global private sector, and that if dollar and foreign currency-denominated assets are viewed by investors as imperfect substitutes, sterilized intervention will cause movements in the exchange rate to reequilibrate supply and demand for dollar assets. The size of this portfolio balance effect would depend on the degree of substitutability between assets denominated in different currencies and on the size of the intervention operation.
The expectations, or signaling, channel holds that sterilized intervention may cause private agents to change their expectations of the future path of the exchange rate. Thus, intervention could signal information about the future course of monetary or other economic policies, signal information about, or analysis of, economic fundamentals or market trends, or influence expectations by affecting technical conditions such as bubbles and bandwagons.
A considerable number of studies have found no quantitatively important effects of sterilized intervention through the portfolio balance channel. Some studies have found expectations or signaling effects of varying degrees of significance. Others conclude that the effectiveness depends very much on market conditions and intervention strategy.
There are serious data and econometric problems in studying this question. To assess success, the researcher needs to know the objective of the intervention and other specific details—was the aim to ameliorate a trend, stop a trend, reverse a trend, show a presence, calm a market, discourage speculation, or buy a little time? The researcher also needs to know the counterfactual—what would have happened if the intervention had not taken place. Also, research on this issue must be placed in the broader context of research on exchange rate determination, which noted above, indicates that it has not been possible to find stable and significant relationships between exchange rates and any economic fundamentals.
As a practical matter, it is difficult to make sweeping assessments about the success or failure of official intervention operations. Some intervention operations have proven resoundingly successful, while others have been dismal failures.
The success or failure of intervention is not so much a matter of statistical probability as it is a matter of how it is used and whether conditions are appropriate. Is the objective reasonable? Does the market look technically responsive? Is intervention anticipated? Will an operation look credible? What is the likely effect on expectations?
In 1983, the Working Group on Foreign Exchange Market Intervention established at the Versailles summit of the Group of Seven warned against expecting too much from official intervention, but concluded that such intervention can be a useful and effective tool in influencing exchange rates in the short run, especially when such operations are consistent with fundamental economic policies.
Unquestionably, intervention operations are more likely to succeed when there is a consistency with fundamental economic policies, but it may not always be possible to know whether that consistency exists.
Although attitudes differ, monetary authorities in all of the major countries intervene in the foreign exchange markets at times when they consider it useful or appropriate, and they are likely to continue to do so.