What is your suggestion for currency trading

Introductory summary

1. In its "stability-oriented monetary policy strategy", the ECB paid very little attention to exchange rate policy. There was hardly any conceptual preparation for a possible massive real decrease or increase in the value of the euro against the dollar. This deficit is particularly problematic in that, under the Treaty, exchange rate policy does not fall under the sole responsibility of the ECB (Art. 111 of the Treaty). In order to avoid conflicts between the Council and the ECB in the event of a currency crisis, a clear conceptual framework is necessary now.

2. Experience with flexible exchange rates since 1973 shows that such a system tends to be markedly unstable. All empirical studies show that there are no systematic relationships between the so-called fundamental data (inflation rates, real GDP growth, current accounts, etc.) and the exchange rate option. That is why stability-oriented national policies cannot guarantee exchange rate stability. The deflationary situation in Japan shows that even an economy with a relatively low export and import share can clearly suffer from persistently incorrect currency adjustments.

3. Thus, the ECB should be able to avoid large mismatches in the euro / dollar exchange rate. In this paper, I am primarily examining whether the ECB would be able to keep an increase in the euro / dollar exchange rate above 1.20 dollars by publicly announcing an exchange rate ceiling.

4. For many observers, the sheer size of foreign exchange markets (with a daily turnover of $ 1,741 billion) prohibits any attempt by central banks to turn certain exchange rate levels against the markets. Due to the "market-maker principle" that structures the foreign exchange market, these numbers represent the underlying changes in internationally held assets. In addition, the effectiveness of central bank interventions depends heavily on the direction in which they are aimed. A central bank's attempt to stop its currency from falling in value is tied to the requirement to follow a budget-set foreign exchange reserve amount. This makes it vulnerable to market speculation. If a central bank wants to ward off an appreciation of its currency, it has the option of buying foreign assets for national assets for which it is not subject to any quantitative restrictions.

5. Articles 105 and 111 of the Treaty clearly prioritize the objective of price stability in all actions of the ECB. Therefore, the impact of foreign exchange market operations on short-term interest rates in the euro area needs particular careful study. With its recently established deposit facility, the ECB is able to sterilize liquidity indefinitely, so that the national currency base and thus national short-term interest rates can be completely isolated from the consequences of the intervention. The instrument of sterilized interventions therefore gives the ECB additional room for maneuver: it can be used to pursue a stability-oriented policy for the euro currency area and at the same time avoid high real euro growth.

6. The literature written on the effectiveness of sterilized interventions is not particularly informative. It is based on half-hearted interventions (those to a very small extent and mostly in secret) by the Bundesbank, the FED and the Bank of Japan over the past 25 years. The important difference between an intervention to prevent an appreciation or depreciation of the national currency is completely ignored in this literature. For the process of publicly announcing the ceiling for the euro-dollar exchange rate, these books do not seem really relevant.

7. For the durability of an intervention policy, the costs of sterilized interventions must be kept within limits. In the case of intervention to prevent the euro from rising, these costs depend on three factors: domestic and foreign money market rates and the value date gains or losses on foreign capital acquired through the intervention. Currently, interest rates in the euro area are lower than in the United States. In this situation, if the ECB were to buy larger (higher interest) dollar sums and at the same time increase the volume of its own (lower interest) deposit facility, it would make a profit. If the dollar is protected from depreciation, then there are no currency losses. In the - hypothetical - case that interest rates in the euro area were to be above the dollar rate, the ECB would have to adjust its exchange rate target to the interest rate differentials. By initiating a slight appreciation of the dollar, it would make up for the loss caused by the interest rate differential.

8. The framework outlined in this work is mainly intended for a unilateral intervention policy of the ECB, which protects against excessive growth of the euro against the dollar. The possibilities of the ECB to defend a depreciation of the euro are much smaller. The logic of sterilized interventions can, however, be used for a bilateral agreement between the United States and the euro area. In such an agreement, the ECB would set and defend an upper limit, for example $ 1.20 per euro, whereas the Fed would set and defend a lower limit, e.g. B. $ 1.00 per euro. Since both central banks would only come into play if the national currency were to grow, they would always be able to successfully defend their exchange rate targets against speculative attacks by the markets. Once again, the margins would have to be adjusted according to the prevailing interest rate differentials. Experience since 1973 shows that this would have led to an extremely sensitive exchange rate path. Compared to the situation in the early 1970s, such cooperation in the field of exchange rate management would have the advantage that both central banks follow clearly stability-oriented monetary policies in their own country.

1. Introduction

While the monetary market policy of the ECB has been discussed intensively in the past few months, the scientific and political discussion has almost completely neglected the ECB's currency policy concept. In its "stability-oriented monetary policy strategy", the ECB paid little attention to this important issue either. In the not unlikely event of a significant increase in the value of the euro exchange rate against the dollar, hardly any conceptual preparations were made.

In the present work I develop a possible framework for the exchange rate policy of the ECB. My focus is on the euro exchange rate against the dollar, but the main arguments also apply to the exchange rates of other currencies, especially the pound sterling and the yen. My work is structured as follows: After a brief description of the ECB's views on exchange rate policy, I turn to the question of why it is important to target the euro / dollar exchange rate. In Chapter 4, I ask two key questions of intervention policy:

  • Are central banks able to protect exchange destinations from the pressures of foreign exchange markets?
  • Is it possible to combine massive exchange rate intervention with a stability-oriented monetary policy?

In the event of a sharp fall in the dollar, I propose a framework that allows an effective upper limit for the dollar rate to be set without endangering price stability in the euro area. This can be achieved with the technique of "sterilized interventions". This instrument gives the ECB additional leeway in its currency and exchange rate policy: while maintaining price stability, it is able to ward off the negative consequences of a greater euro appreciation for profits, growth and employment in the euro area. The strategy described in this work thus helps the ECB to meet the requirements set out in Article 105 of the Treaty, i.e. also to pursue other macroeconomic objectives, provided this is compatible with the objective of price stability. 1 Chapter 5 shows how this framework can be applied to a bilateral Cupertino exchange rate with the United States.

The focus of the work is the dollar exchange rate. Other major issues of the ECB's exchange rate policy, including exchange rate relations with the EU member states that are not yet part of EMU, and with the candidate countries and countries of Eastern Europe and the NIS are not addressed. Nor should it be judged what a balanced dollar / euro exchange rate looks like; rather, calculations made in the current literature are implemented.

2. The exchange rate policy concept of the ECB

In the detailed "stability-oriented monetary policy strategy" 2 The ECB deals with the role of exchange rate policy in just two sentences:

"In the current circumstances - which show neither a formal exchange rate agreement nor any general direction - the euro exchange rate is the result of current and anticipated monetary and other policies both in the euro area and elsewhere, as well as the adoption of these policies by market participants The Eurosystem’s monetary policy strategy does not include an exchange rate target for the euro, the task of focusing on maintaining price stability in the euro area is simplified. " (ECB 1999, p. 42)

As a general concept, the ECB expressly excludes "an implicit or explicit exchange rate target for the euro" (Duisenberg 1999, p.1). As a result, it fell during the euro’s depreciation against the dollar in the first seven months of 1999 3 opted for a policy of "moderate non-compliance".

In speeches by President Duisenberg and his board members 4 it becomes even clearer what the reason for this approach is:

  • "(...) aligning monetary policy decisions to such an exchange rate target may mean a conflict with the goal of price stability in the longer term." (Duisenberg 1999, p. 1)
  • "(...) stability-oriented macroeconomic policies implemented transparently are the best contribution politicians can make to maintaining exchange rate stability. In other words, misadjustment and excessive volatility should be contained by researching their root causes." (Duisenberg 1999, p. 1)
  • "(...) in a world characterized by integrated and extremely liquid international financial markets, there are serious doubts about the possibility of fixing exchange rates or of setting them as a goal." (Duisenberg 1999, p. 2)

In other words, the ECB's exchange rate strategy is based on the assumption that an explicit / implicit exchange rate policy by the ECB is generally neither feasible nor necessary. In addition, in the view of the ECB, interventions in foreign currencies would jeopardize price stability. Despite these clear statements, President Duisenberg does not completely rule out the possibility of currency fluctuations causing serious economic problems for the euro area.

"Clearly incorrect exchange rate adjustments, while difficult to detect, would be problematic for the Eurosystem. If they persist, they can affect inflation forecasts and distort economic activity by hindering the efficient allocation of funds." 5 (Duisenberg 1999, p. 2)

However, this statement leaves open what "persistent" and "clearly incorrect currency adjustments" mean for the ECB and how it would react in such a situation, should it arise. This deficit is particularly problematic in that, under the Treaty, exchange rate policy does not come under the sole competence of the ECB. Article 111 (2) of the Treaty - formerly Article 109 (2) states:

"If there is no exchange rate system in accordance with paragraph 1 with respect to one or more third country currencies, the Council, acting by a qualified majority, either on the recommendation of the Commission and after hearing the ECB, or on the recommendation of the ECB, can draw up general guidelines for exchange rate policy towards these currencies. These general guidelines may the primary objective of the ESCB, to ensure price stability, does not affect ".

In view of this important role mentioned in the Treaty, it is quite astonishing that the relationship between exchange rate policy and maintaining price stability has not been systematically discussed to date. Above all, an early clarification of these aspects seems necessary in order to avoid conflicts between the Council and the ECB in times of currency instability. 6

3. Are Forex Market Interventions Really Necessary?

In order to discuss the ECB's exchange rate policy, it is necessary to first briefly discuss the theoretical basis and empirical evidence of flexible exchange rates. In addition, the importance of serious currency mismatches in the euro area needs to be examined.

3.1 Flexible exchange rates and macroeconomic sizes

The theoretical starting point for a discussion of the ECB's exchange rate strategy is the fundamental question of how exchange rates are defined in a system of floating exchange rates. According to many economists, the exchange rate is primarily the result of macroeconomic variables, so-called fundamental data (in particular: inflation rates, interest rates, current accounts, tax deficits, real GDP growth, money stock). The exchange rate is therefore primarily used as a stabilizer in the world economy. This view also formed the theoretical basis of the proponents of flexible exchange rates in the 1960s:

"Flexible exchange rates allow each country to pursue the mix of unemployment and price targets that it prefers and that is compatible with the internal equilibrium created by an increase in the value of the currencies of" price-stable "countries relative to the currencies of" full employment "countries "is secured (Johnson 1972, p. 210)

According to other economists, however, flexible exchange rates are only marginally influenced by fundamentals and can thus become a real source of macroeconomic instability:

"If the foreign currency market behaves as it has to do according to economic textbooks, with omnipresent rational expectations as the driving force, then it is indeed difficult to imagine why everyone would want to prohibit the exchange rate from fluctuating freely (at least in countries that support the membership in an optimal currency area does not meet the conditions set) (...). The rejection of free fluctuation is based on the statement that capital markets in general and foreign currency markets in particular follow herd behavior rather than rational expectations. " (Williamson 1999, p. 1)

For his part, President Duisenberg clearly prefers the first view of flexible exchange rates:

"(...) stable euro exchange rates is best served by stability-oriented policies that are consistent with economic variables." (Duisenberg 1999, p. 2)

The main problem with this view - shared by most central bankers (Tietmeyer 1999) - is that it is generally not possible to bring it into line with reality. Countless econometric studies on the determinants of flexible exchange rates have been published over the past 25 years. Almost all of them conclude that fundamental economic variables - even if they are well defined - have no systematic effect on the exchange rate in a floating system for at least four to five years. Isard (1995, p. 138) sums up this evidence as follows:

"In short: Neither the theoretically recommended behavioral relationships nor the information obtained through autoregression have led to a model that could predict significantly better than a random market. Even more, while the random market model is at least on a par with other models, it only predicted slightly."

In other words: The best way to predict the exchange rates to be expected tomorrow, in a month or in a year, is based on today's exchange rate. Although this so-called "random path method" 7 Far from perfect, it is at least on par with any other sophisticated model based on "fundamentals" or other factors.

This result also shows that until July 1999 the weakness of the euro against the dollar was explained ad hoc in terms of actual GDP differentials. 8 As Figure 1 shows for the years 1982 to 1999, there is absolutely no systematic link between real GDP growth differentials and the D-mark / dollar exchange rate.This becomes particularly clear for the years 1990 to 1993, when the growth differential (real GDP of the United States minus real GDP of Germany) jumped from -5.9 to +3.5, while the exchange rate was within a range of 1.55 and 1.65 marks per dollar remained remarkably stable.

The theoretical framework on which the ECB appears to base its exchange rate policy is not based on specific empirical research 9. Stable quantities are a necessary, but not sufficient, condition for exchange rate stability. This means that a significant appreciation or depreciation of the euro against the dollar cannot be ruled out, even if stability-oriented policies are practiced in the United States and in the euro area. A look into the not too distant past reveals two great examples of particularly large "mismatches" between the three large currency reserves:

  • Between January 7, 1980 and February 25, 1985 the D-Mark fell from 1.7080 D-Mark / Dollar to 3.4525 D-Mark / Dollar
  • between April 27, 1990 and April 19, 1995, the dollar fell from 158.9 yen / dollar to 81.12 yen / dollar

In both cases the country practiced with the falling currency (Germany in the 80s, the USA in the 90s) clearly "stability-oriented policies". US macroeconomic policies were certainly too slack in the early 1980s and the Japanese economy suffered from the fallout from a burst asset price bubble in the early 1990s, but this would have required depreciation in both cases, but not extreme growth in its own Currency.

3.2 Are exchange rates still relevant to the euro area?

One of the greatest advantages of European Monetary Union is that it makes the euro area less vulnerable to exchange rate instability as such. The share of GDP in trade in the euro currency area with other countries is now around 13%, which is a good half below the total for the eleven countries before EMU. This ratio is comparable to the figures for the USA (ten percent) and Japan (nine percent). If the other four EU member states join EMU, the share of foreign trade falls to ten percent. (AMUE 1999)

However, this relatively small share of extra-EMU trade does not mean that major exchange rate changes can be neglected in the ECB's monetary policy:

"(...) by its effects on economic activity and prices, the exchange rate affects the prospects for price stability and thus undoubtedly plays an important role in the monetary policy of the Eurosystem." (Duisenberg 1999, p. 1)

The great economic problems of Japan are the most obvious example of the sensitivity of even a relatively closed economy to a persistent and severe false adjustment of its currency:

"Implicit and explicit constant pressure from the United States to change the yen growth from 360 units per dollar in 1971 to 80 in 1995 is the historical origin of today's deflationary psychology in Japan." (McKinnon 1999, p. 77). 10

In the case of flexible exchange rates, even reverse causality is possible in such a way that the fundamentals are determined by exchange rate developments 11. The deflation in Japan can clearly be attributed to the extreme appreciation of the currency. Japanese firms were forced to significantly lower their prices and / or profit margins (or even accept losses) in order to remain reasonably competitive with foreign producers.

In today's global economy, the greatest danger is a significant dollar depreciation against the yen and the euro. The IMF (1999, p. 41) comes to the conclusion that the current subliminal current account deficit is 12 of the United States is currently 3.3% of its GDP. This will lead to growing stocks of external liabilities in the USA - the IMF estimates them to be around 20% of GDP for 1999 and a little less than 30% for 2004. With this enormous and growing amount of US liabilities in foreign - mostly Japanese - owned, US currency, the US currency is becoming increasingly susceptible to all kinds of shocks.

The so-called "J-curve effect" is particularly problematic in this context. It is based on the observation that the price effects of a devaluation occur faster than the quantitative effects. Therefore, a large depreciation would temporarily widen the US trade deficit (imports would become more expensive), which could lead to an even greater depreciation. After a while, US imports would of course increase in volume and import volumes would fall, but in the meantime such an exchange rate shock would not bode well for the global economy.

A return in the dollar / euro exchange rate to around $ 1.20 per euro is what a consensus would call "balanced rate" (Figure 1). Such a course is of course extremely difficult to identify, especially after the change in the EMU system. However, any further impairment could become extremely dangerous for the global economy. In the US, a large depreciation of the dollar would result in greater inflation, which would require an even more restrictive interest rate policy. This would move the US economy into a major recession. In the euro area and in Japan, a greater appreciation of their own currency would further weaken what is, in a sense, the still weak economic upswing. All in all, uncontrolled dollar depreciation would lead to a massive global recession.

Table 1: Estimates for a balanced euro / dollar exchange rate

Purchasing power parity (OECD)1,05
PPP trend (Warburg Dillon Read)1,15
Fundamental balanced exchange rate (Institute for International Economics)1,15-1,40
Purchasing power parity (Deutsche Bank)1,16
Fixed price model (Deutsche Bank)1,16
Real interest rate and M1 (Deutsche Bank)1,16
Nominal Money Growth (Deutsche Bank)1,15

Source: BIS (1999), Deutsche Bank Research (1999), Wren-Lewis (1999)

3.3 An ambitious intervention strategy

It therefore makes sense for the ECB to work out an understandable framework for its exchange rate policy in a reasonable time. In the following I will propose and examine a particularly far-reaching intervention strategy. I suspect the ECB is trying to stop an appreciation of the euro by publicly announcing an upper limit for its dollar exchange rate. This presupposes that the ECB is willing and able to intervene indefinitely in the foreign exchange market.

This procedure is based on the " Portfolio balance channel"like that" Signaling channel"of interventions 13. According to the portfolio balance sheet channel, the exchange rate is stabilized when the central bank is ready to accommodate portfolio adjustments by the private sector by buying or selling foreign currency. According to the signaling channel, exchange rate prospects can then be stabilized if the central bank provides market information on its further monetary policy or its further exchange rate targets. The effectiveness of the signaling channel depends on the credibility of the announced exchange rate target. If such an announcement is really credible, there is hardly any need for intervention.

Focusing on an exchange rate strategy that is as ambitious as possible has the advantage of being able to clearly identify the main problems of the ECB's money market interventions. If necessary, less comprehensive strategies will be developed.

4. ECB exchange rate targets: scope and limits

Any proposal for an active exchange rate policy by the ECB is faced with two extremely difficult questions:

  • Is the ECB in a position to defend an exchange rate target against potentially enormous pressures from foreign exchange markets?
  • Is such an exchange rate policy compatible with the main objective of the ECB to maintain price stability in the Eurosystem?

The second question is also highly relevant to the definition of the role of the Council in the ECB's exchange rate policy.

4.1 Forex Market Sizes

According to many observers, the sheer size of foreign exchange markets precludes a systematic handling of exchange rates even by the central bank of a large currency area. 14 According to calculations by the Bank for International Settlements (1999, p. 117), the average dollar Daily turnover15 in 1998 forex markets $ 1,741 billion. Even given the fact that this number represents the sales that a particular currency makes appear on one side of a transaction, so that as a result each transaction is counted twice, the numbers look impressive. Compared to the EUR 350 billion gold and currency reserves of the entire Eurosystem, the ECB appears to have little firepower against foreign exchange attacks.

However, to understand these sales figures clearly, one must understand how foreign exchange markets are organized. One of its most important features is that " Market maker principleThis means that all participants in the interbank foreign exchange market are ready at any time to buy and sell unlimited currency, regardless of whether there is an additional need for foreign currency or their own currency at the time. Since every participant is able to purchase one To dispose of unwanted items immediately, the risk of determining the market (becoming a "market maker") is extremely low. This foreign exchange market organization has the effect of inflating the total turnover. As Figure 2 shows, an order from a German company, Buying dollars for 100 euros leads to various intermediate transactions between the market makers before this item reaches a bank that needs euros for its customers.

Diagram 2: Market maker principle

Due to the speed at which intermediate transactions take place, a particularly high multiplier between an external transaction and the internal transactions cannot be ruled out. Likewise, any foreign exchange intervention by a central bank has the same strong multiplier effect. 16 As a result, it makes little sense to compare foreign exchange reserves with the daily turnover in foreign exchange markets.

4.2 Two directions of intervention policy

Nevertheless, even taking into account its own foreign exchange market logic, it cannot be ruled out that sooner or later the ECB will run out of reserves. In order to assess the effectiveness of foreign exchange market interventions, it is therefore particularly important to know in which direction an intervention is taking place:

  • A central bank can try its own currency in the case of one Depreciation to maintain a certain level. Such a defense against market pressure has to take place within the framework of specific budget restrictions for foreign exchange reserves (and existing credit lines with other central banks and international institutions). In such a situation, a central bank is therefore always faced with the risk that its exchange rate policy will run out of ammunition. As the currency markets foresee such a situation, the central bank becomes susceptible to "speculative attacks" in an attempt to hasten the running out of reserves.
  • The situation is completely different as soon as a central bank tries to establish one Increase in value limit their currency. It buys foreign currency against central bank balances (issued in its own currency), which it can deliver without any quantity restrictions. Since there are basically no budget restrictions, speculative attacks are no longer a real danger.

As a result, from the ECB's point of view, there is a considerable difference between defending a rising or falling euro. In the concrete situation of the first seven months of 1999 it would have been much more difficult to stabilize the exchange rate between the euro and the dollar than in the still hypothetical situation of a sharp decline in value of the dollar.

4.3 Foreign exchange market operations and national monetary policy

The mere fact that the ECB is able to prevent dollar losses against the euro does absolutely not mean that such a policy is desirable. Given the main responsibility of the ECB to maintain price stability, it is important to examine the impact such an intervention policy has on the price level in the euro area.

For many economists, but also for the ECB, an active intervention policy is incompatible with an autonomous monetary policy. This attitude is shown in the so-called "Inconsistency triangle", according to which it is not possible to combine fixed exchange rates with free capital movements and autonomous monetary policies (Figure 3).

Diagram 3: Inconsistency triangle

At first glance, this sounds really convincing: Foreign exchange market interventions have a direct effect on the monetary base (e.g. the sum of commercial bank reserves plus central bank and currency assets).

  • If the ECB buys foreign currency from a commercial bank, its ECB account is credited in the corresponding amount. 17 This results in an increase in the monetary base in the euro currency area.
  • If the ECB sells foreign currency from a commercial bank, its ECB account is debited in the corresponding amount. This results in a decline in the monetary base in the euro currency area.

Since the monetary base can be viewed as a major input to the national monetary (or credit) process 18, such intervention-driven changes in the monetary base have far-reaching consequences for the euro area economy. For example, an attempt to limit an increase in value would be associated with an increase in the national monetary base. Seen in isolation, such an intervention policy would have de facto inflationary effects.

In practice, however, most central banks seek to neutralize the effects of interventions on the monetary base, to " sterilize"In order to keep the rates of your own currency constant. This is possible

  • in the case of one enlargement the monetary base by reducing the credit the central bank offers to commercial banks and / or by offering commercial banks interest-bearing savings that cannot be used for national credit expansion. For this specific purpose, the ECB has created a new instrument, the "deposit facility", at its own disposal. In the event of massive intervention, the interest rate on this deposit facility determines money market rates in the euro area.
  • in case one Decline the monetary base: the commercial banks are then granted additional credit. If a central bank works with refinancing facilities (the "marginal lending facility" at the ECB), this compensation is automatically taken care of.

It must be noted that sterilization is defined here as a policy that leaves the national money market unchanged. 19 This is consistent with the widespread belief that national short-term rates are the primary target for monetary policy operations and thus the driving force behind the entire monetary policy transmission process 20 With this definition of the term "sterilization" it is possible to store euro and dollar money. For example, should the euro become the subject of speculation, international investors would hold higher stocks of short-term euro deposits and fewer dollar deposits, or even have short-term dollar outstanding debts). These changes in the money supply have no effect on the domestic economy in that the wealth is only used for speculative purposes.

The experience of the GermansBundesbank show that a large central bank can sterilize even extremely large volumes of intervention. When the ERM got into the crisis in autumn 1992 and summer 1993, the Bundesbank sterilized amounts of 92 billion DM (September 1992) and 60 billion DM (in July 1993, over half of which on 30 July 1993). Despite these violent interventions, the short-term exchange rates could consequently have been kept at the levels determined by the repro and discount rates of the Bundesbank. 21

In order to be able to protect the euro from appreciation against the dollar, the ECB has an intervention instrument with its deposit facility that allows national money market rates to be kept at exactly the level required to maintain price stability in the euro currency area. As there are no limits to this facility, such interventions cannot affect monetary conditions in the euro area. This leads to the important conclusion that foreign exchange intervention to prevent excessive euro appreciation should not jeopardize the objective of price stability in the euro area.

Diagrams 2 and 3 show the mechanisms of sterilized interventions for a significantly simplified ECB balance sheet. The starting point is that the intervention amount (4,000 euros) is higher than the loans granted by the ECB to commercial banks (1,000 euros). As a result of the sterilization, these credits drop to zero and the excess liquidity flows into the deposit facility. It should be noted that the monetary base and consequently also the national money market rates remain absolutely untouched.

Table 2: Simplified ECB balance sheet before a sterilized intervention

Foreign exchange reserves1.000Commercial bank reserves   500
Loans to national commercial banks1.000Currency in circulation1.500

Table 3: Simplified ECB balance sheet after a sterilized intervention (4,000 euros)

Foreign exchange reserves5.000Commercial bank reserves   500
Loans to national commercial banksMonetary assets1.500
Deposit facility3.000

As a result, it can be concluded that the ECB is constantly in a position - even under extremely strong pressure from the market - to beat the euro ahead of a Increase in value to protect against the dollar.

  • Since it buys dollars and delivers central bank deposits in euros, there are no budget restrictions on the ECB's interventions.
  • With its (unlimited) deposit facility, it can at all times hold the excessive liquidity created by such interventions. The deposit facility rate makes it possible to fix bid rates in the euro area independently of the intervention policy.

In this specific situation, sterilized interventions give the ECB additional freedom of action. It is allowed to target national interest rates at the same time as an upper limit for the exchange rate between the euro and the dollar. In the case of a euro Depreciation the intervention policy of the ECB would look much more difficult, since it would be tied up by a predetermined amount of foreign exchange reserves. As a result, the credibility of such interventions is significantly lower from the outset.

It should be noted that the "signing effect" of sterilized interventions, as often discussed in the literature, is not relevant:

"According to this 'signaling hypothesis', the central bank's foreign exchange market operations can be used to indicate impending changes in monetary policy." (Vitale 1997, p. 2)

Since sterilized interventions allow a national monetary policy to be independent of the exchange rate policy, they can only have a signaling effect for the further exchange rate, but not for further national monetary policy actions of the central bank. If, on the other hand, the signaling effect is understood as a signal for the further exchange rate (Dominguez and Frankel 1993, p. 1356), then the concept of sterilized interventions can have an extremely strong effect, provided it comes into play in an environment where the domestic currency is growing in value. In this situation, the ECB could make it credibly clear that it is able to absorb currency indefinitely via the portfolio channel. With such a strong signaling effect, very likely little intervention is required via the portfolio channel.

4.4 The cost of sterilized interventions

A major problem with sterilized interventions is that they are not always "free food". The cost of sterilized interventions directly affects a central bank's profits. They are determined by three factors: 22

  • the Interest rate for foreign assets, that the central bank buys as part of the intervention. Since central banks usually invest their reserves in liquid form, this interest rate is more or less the same as the foreign bid rate.
  • the Interest rate of the deposit facilitywith the national commercial banks investing their excess liquidity. Since the interest rate on the deposit facility is designed to hit the national bid rate, it is extremely close or equal to it.
  • that caused by the rise or fall in the price of assets that the central bank buys through its interventions Value date loss or gain.

I then go into more detail about a central bank's currency purchases in order to avoid excessive appreciation of its currency.

The interest rate differential between domestic and foreign bid rates is clearly a determining factor in the costs or benefits of sterilized interventions. A distinction must be made between two cases:

Is there a domestic rate under the foreign exchange rate, the central bank falls back on the sterilized intervention. The interest income it takes on its overseas assets is greater than the interest cost on the deposit facility. As long as the exchange rate is constant, currency gains or losses can be disregarded. For the near future, an intervention policy by the ECB aiming at an upper limit for the dollar exchange rate of the euro would face this - but rather attractive - situation. Since the ECB can prevent a decline in the dollar at any time, the risk of currency losses would be extremely low. Should her intervention lead to a rise in the dollar, she would even write currency gains.

The situation is far more difficult once the domestic interest rate above the foreign rate. The sterilized intervention is then equated with constant central bank losses. In the past, various central banks (including the Czech National Bank until the Koruna crisis in May 1997) were confronted with this problem. Since these costs cannot be borne indefinitely, the sterilized interventions have to contend with budget restrictions. Similar to budget restrictions for certain reserve amounts, an intervention policy threatens to become susceptible to speculative attacks.

This problem can be solved relatively easily, since the loss of interest rate can be compensated at any time by a currency gain. This requires the central bank to focus the exchange rate in such a way that the national currency falls in line with the prevailing interest rate differential against the foreign currency. The logic of this approach can be explained using the situation that prevailed in the first half of 1999. Let us assume that the Fed had tried to prevent the euro from devaluing against the dollar by means of a sterilized intervention of no more than $ 1.00 per euro. 23 With an interest rate differential of 1.75% to 2.25% in favor of the dollar, the Fed would have posted losses. This could have been prevented by adjusting the exchange rate target in the form of a depreciation of the dollar against the euro that exactly corresponds to the interest rate differential. Assuming a limit of $ 1.00 per euro, for example, the Fed would have had to announce that the limit would have been adjusted to around $ 1.02 after a year at the latest. Such an exchange rate path would have been possible since a central bank is basically empowered to drop its own currency through sterilized interventions. Sterilized interventions can in principle be free of charge, but they can also be unprofitable if a central bank aligns the exchange rate on a path dictated by the prevailing interest rate differential.

In the first case, which is characterized by domestic exchange rates above foreign exchange rates, such a rule would be superfluous. However, even under such conditions, it seems advisable to follow them. Suppose the ECB sets its upper intervention limit at $ 1.25 per euro. If this target is viewed as credible over a longer period of time, higher interest rates in the US than in the euro area would push the spot rate below this limit in line with the interest rate differential. 24 At the current interest rate differential of around 2.75 basis percentage points, the spot rate would be $ 1.2165. The current limit would thus be below the target level. This could be avoided if the EBZ announced its readiness to adjust its upper limit in line with the interest rate differential.

4.5 Effectiveness of Sterilized Interventions

The analysis of my work shows that a general assessment of the effectiveness of sterilized interventions is not possible. It makes a big difference whether a central bank tries to avoid an upper bound (to prevent its currency from appreciating) or a lower bound (to prevent its currency from depreciating). Any attempt to fight against devaluation is jeopardized by budget restrictions on a certain reserve amount with negative symbolic properties. The situation is completely different if the value of the local currency increases. In this case, the symbolic effect is drastic and reduces the need to purchase larger amounts of foreign currency.

This assessment is not entirely compatible with older information on sterilized interventions, which Dominguez and Frenkel (1993, p. 1356) summarize as follows:

"Until recently, there was an unusually large consensus among economists that central bank intervention in the currency markets was not an effective or sustainable tool for changing the exchange rate, at least not independently of monetary policy."

This view is not only represented in more recent publications (including Dominguez and Frenkel 1993, Vitali 1997, Fatum and Hutchison 1999), it is also based on the concrete manner in which such interventions are carried out. Despite publicly announced exchange rate targets, most of these interventions were carried out in secret, so that the signaling effect could not come to fruition. 25 In addition, the central bank was only willing to intervene with relatively small amounts. 26 In the previous specialist literature, the fact is not taken into account that it makes no difference whether interventions take place in the event of a decrease or increase in the value of the national currency.

5. Bilateral agreements in intervention policy

My work shows that the ECB would always be able to avoid an unjustified appreciation of the euro against the dollar (but also other currencies such as the pound sterling or the yen). It is clear that such a unilateral exchange rate policy can lead to growth and employment without jeopardizing the price stability objective. With an uncontrolled Depreciation the euro, on the other hand, the ECB's room for maneuver is significantly less. A more understandable presentation would therefore include a bilateral agreement between the United States and the euro area, which aims to keep the exchange rate between the euro and the dollar within a reasonable range. The bandwidths would be fixed

  • from the ECB at the upper limit of the exchange rate between the euro and the dollar, for example at 1.20 dollars per euro and
  • by the Fed at a lower value of the exchange rate between the euro and the dollar, but corresponding to an upper limit, e.g. B. 1.00 dollar per euro.

The range would take into account the conceptual difficulties in finding balanced exchange rates. As has been shown so far, both central banks would be able to defend their respective borders against the most violent attacks on the foreign exchange markets. In order to protect such interventions from costs, the limits would have to be adjusted in the longer term in accordance with the prevailing short-term interest rate differentials. This would lead to the bilateral range of the exchange rate between the euro and the dollar being determined by the prevailing interest rate differentials. Figure 4 shows a hypothetical bilateral agreement effective January 1, 2000.

Diagrams 5 and 6 show what such a rule would have meant for the Deutsche Mark / dollar and yen / dollar exchange rates in the past. Above all, it would have prevented the greatest mismatches and pointed a path close to that which can be calculated from the bilateral inflation differentials. Given that inflation rates are one of the most important determinants of nominal interest rates, such a result is not surprising. The important role of Taylor's rule shows the cyclical position as measured by the output gap - another important factor in short-term interest rates in the euro area as in the United States (Bofinger 1999). Thus, the range would show fluctuation commensurate with the differences in the cyclical position of the United States and the euro area.

As a bilateral agreement, the scheme shown would have the advantage of preventing serious mismatches in the dollar / euro exchange rate. At the same time, the Fed and the ECB would have the ability to set short-term interest rates taking into account the inflation rate (prevailing or expected) and the output gap that exists in their economies. An important precondition for any bilateral agreement on exchange rate stabilization is, of course, one stability-oriented tax and monetary policy in both currency areas. In the late 1960s and early 1970s this precondition was not met; today it is granted in the United States and in the euro area.

Such a bilateral agreement can also be applied to relations between Japan and the United States. A credible limit for the yen's appreciation against the dollar would be a simple but highly effective way of stabilizing Japanese corporate and household confidence. 27

If the proposed framework is applied bilaterally, it offers a way out of the "inconsistency triangle". The only change is to be made in the "fixed exchange rates". If "fixed rates" are defined as "fixed rates adjusted according to the interest rate differential", then the "inconsistency triangle" becomes a "consistency triangle". This enables a combination of autonomous monetary policies and free capital movements at exchange rates, which are only adjusted according to the normally very low interest rate differentials.

Diagram 7: Consistency triangle

6. Conclusion

This work shows that an active exchange rate policy of the ECB is absolutely possible without endangering price stability. With the instrument of sterilized intervention, the EBZ is able to avoid a large real increase in the value of the euro and, at the same time, to operate an interest rate policy that is designed for price stability in the euro currency area. The considerations presented are of course only to be understood as a first draft of such a policy, but make it clear that the exchange rate policy of the ECB is a topic that deserves much more discussion and analysis than in the past. This is particularly true because the responsibilities of the ECB and the Council in this domain are not clearly defined. Only a timely clarification of the relationship between price stability and intervention policy can help avoid a difficult and presumably damaging debate in times of crisis.

The focus of the work is the consideration of the intervention mechanisms. Therefore no attempt was made to make new estimates for a balanced exchange rate between the euro and the dollar. Before an active exchange rate policy can be implemented, a thorough empirical analysis of this issue is required.


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(1) Article 105 (1): "The primary objective of the ESCB is to ensure price stability. As far as this is possible without prejudice to the objective of price stability, the ESCB supports general economic policy in the Community in order to achieve the objectives set out in Article 2 established goals of the community. "

(2) see ECB (1999); for an understandable analysis and discussion of the strategy see Bofinger (1999).

(3) The Eurosystem's foreign exchange reserves even increased during this period: in January 1999 they amounted to 230 billion and on 30 July 1999 to 245 billion. The maximum weekly intervention rate was reached between 21 May 1999 and 28 May 1999, the Foreign exchange reserves reached 3 billion euros at this time.

(4) See also Issing (1999).

(5) Of course, in situations of major mismatch, not only financial but also sectoral real resources are allocated inefficiently.

(6) On April 19, 1999, President Duisenberg said at a hearing before the European Parliament's subcommittee on monetary issues: "The European Council in Luxembourg in December 1997 had decided and announced that general political directions on exchange rates would only be given in exceptional circumstances , for example in the event of a serious mismatch in currencies ". However, this still leaves it completely open how "serious mismatching" is to be defined.

(7) Cf. Williamson (1999, p. 2): "It remains true that a random market outperforms any other structural model of exchange rate setting for a time outlook of a maximum of one year. But it is now fairly certain that a freely fluctuating rate is slow falls back to relative purchasing power parity (PPP), with half of the adjustment likely to be achieved in less than five years ... "Although the exchange rate is also a major determinant of the inflation rate, it is not clear whether the exchange rate adjusts to the inflation rate or vice versa.

(8) Cf. Duisenberg (1999): "This makes it clear that the most recent developments in the euro exchange rate primarily reflect the previous unexpected strength of the US economy."

(9) This also applies to the experiences made between the two world wars with freely fluctuating exchange rates, to which Nurlse made careful investigations (1944, p. 211): "The dangers of such cumulative and self-aggravating movements in a system of freely fluctuating exchange rates are clearly shown in France's experience of 1922-26. Exchange rates in such circumstances inevitably become extremely unstable and the influence of psychological factors becomes at times overwhelming. French economists were so impressed by this experience that they came up with their own "psychological theory" of exchange rate fluctuations , in which they have emphasized the indefinite nature of exchange rates, which should find their level on their own in a speculative market (...) Instead of encouraging adjustments in the balance of payments, such aggravating movements can exacerbate and accentuate any initial imbalance call out what might be called "explosive" instability conditions. "

(10) For a more detailed analysis see McKinnon and Ohno (1997).

(11) This reverse causality is often overlooked in the literature. Eijffinger and Verhagen (1997, p. 27), for example, conclude that "sterilized interventions cannot systematically adversely affect the exchange rate (...). This result goes back to (...) the central bank's inability to achieve a goal which differs from the underlying fundamental data trend of systematically tracking (...) ".

(12) The IMF defines the actual current account deficit as "the balance sheets that would prevail if all countries were to operate at full power after working through the effects of past exchange rate changes. These are those balances that are currently active in the medium to long term Exchange rates with zero output gap would prevail. " (IMF 1999, p. 40)

(13) see Eijffinger and Verhagen (1997, p. 2).

(14) Cf. also Eijffinger and Verhagen (1997, p. 2): "On the other hand, it is hardly likely that central banks can cause a significant imbalance in fixed assets since the official reserve amounts have been exceeded by daily turnover on the currency markets."

(15) Net local inter-dealer double counting.

(16) Cf. Vitale (1997): "In the week of August 3-7, 1992, when the press did not read about any special events, the daily transaction volume with customers exchanging Deutschmarks for dollars reached Merrill Lynch was around $ 1 billion. The average size was about $ 4 million. These figures show that the central bank, even with a relatively small market order, can affect the price of a single market maker Central bank market orders, interdealer transactions transfer this effect to the prices of other dealers. "

(17) What is not one hundred percent correct: the commercial banks in the euro area maintain accounts with the state central banks, but not directly with the ECB.

(18) Cf. Bofinger et. al (1999).

(19) Dominguez and Frankel (1993, p. 1356) give a different definition: "The specialist literature is based on the difference between sterilized and those interventions that are allowed to change the supply of money."

(20) See also Chapter 10 in Walsh (1998).

(21) See Deutsche Bundesbank (1993a, p. 23) and Deutsche Bundesbank (1993b, p. 17).

(22) Another definition of the costs of sterilized interventions is given by Eijffinger and Verhagen (1997, p. 6): "These costs can be explained with transaction costs and the fact that the central bank writes losses on its purchases (sales) of foreign currency when it is unsuccessful in its attempt to protect the national currency from appreciation (depreciation) ”. It seems obvious that this definition is incorrect.

(23) From the Fed's point of view, too, this would have been an upper limit. With a limit of 1.00 euros per dollar, it would have prevented rates below 1.00 dollars per euro - which, from a dollar point of view, would correspond to more than 1.00 euros per dollar.

(24) This corresponds to the logic of the "open interest parity theory". According to this theory, the difference between the expected and current exchange rates (divided by the spot rate) equals the difference between the domestic and foreign interest rates.

(25) Dominguez (1998, p. 161) concludes: "Open interventions in the mid-1980s apparently reduced exchange rate volatility (...)."

(26) see Dominguez and Frenkel (1993, p. 1357): "(...) the coordinated intervention activities to support the dollar in the period from January 1985 to December 1988 averaged $ 278.5 million, the In contrast, coordinated sales of dollars averaged $ 373.2 million. "

(27) See also Wolf (1999).

Publisher information


European Parliament
L-2929 Luxembourg

AUTHOR:Peter Bofinger
Bavarian Julius Maximilians University of Würzburg and CEPR
European Parliament
Directorate-General for Science
Tel .: (00352) 4300-24114
Fax: (00352) 4300-27721
Internet: [email protected]

The views presented are those of the author and do not necessarily reflect the position of the European Parliament.

Reproduction and translation - except for commercial purposes - are permitted provided the source is acknowledged, provided the publisher is informed in advance and a copy is sent to him.

Manuscript completed in September 1999.

© European Parliament: 09/1999