The Curious Case of Missing Intervention

by: Joseph Trevisani

Has central bank currency intervention gone out of style? Two extreme cases in the past year should have beckoned intervention: the all time high of the euro against the dollar last summer and the 15 year high of the yen in late January. But despite the damage that was being done to the European and Japanese exports by their strong currencies neither central bank intervened. Why have central bankers eschewed one of their primary tools for effecting violent change in the currency markets?

At the time, Jean Claude Trichet, the President of the European Central Bank (ECB), certainly tried to talk the euro down. He was ‘concerned’ about ‘disorderly’ currency movements, central bank euphemisms for what the bankers see as incorrect trading rates. There was also no shortage of European complaints about the level of the euro and praise for the United States ostensible strong dollar policy.

The Japanese, on the other hand, had little to say when the yen was at 87 in January besides noting that the level was bad for exports.

Central bank interventions in the currency markets have a chequered history. One only has to remember George Soros’ great bear raid on the pound in 1992 or the violent gyrations of interest rates in defense of the European Rate Mechanism to know that even central banks cannot stand against the combined weight of the world’s currency traders.

But there are also several instances of successful central bank interventions in the currency markets since 1985, including the Plaza Accord of that year, the Louvre Accord two years later, the intervention by the US and Japan in 1995 and 1997, and the G7 support of the euro in 2000.

This brings us to the two most crucial attributes for successful currency intervention. By successful we mean that the targeted exchange rate continued to move in the direction desired by the banks even after the pressure of direct intervention was withdrawn.

The primary condition for successful currency intervention is that it must align with central bank rate policy and the supporting macro economic conditions.

For example if the banks are trying to boost the value of the dollar it cannot be done if the Federal Reserve is reducing rates relative to other countries. When bank intervention is aligned with rates or is a credible precursor to a change in rate policy then the powerful nudge of intervention can galvanize the entire currency market.

The second condition, coordinated efforts by several central banks, is operational but nevertheless essential in convincing the currency markets that the banks have serious intent. When the US and Japan intervened together in 1995 and 1997 to affect the value of the dollar and the yen the markets listened. When Japan has intervened alone, the markets ignored the effort. Coordinated intervention is needed to impress the banks' desire on the 24 hour three trillion dollar a day currency markets. One bank in one market is simply not enough.

Prior to Trichet's July 2008 admission that European growth was suspect, the ECB focus had been inflation. The governors had raised rates a few weeks earlier; the American Federal Reserve had been lowering rates since the previous fall. No amount of bank intervention would have permanently dented the value of the euro against the dollar if the rate equation had remained unchanged.

Before the public alteration of the ECB economic outlook both the Europeans and the Americans had repeated the strong dollar US policy. Many traders had met the US assertions with skepticism because rising US exports, largely due to the weak US dollar, were the only positive sector of the American economy at the time.

Despite the desire of the Europeans and perhaps the Americans to bolster the dollar in mid-2008, it was clear that conditions for successful intervention did not then exist. It is also possible that by mid-July the ECB had become aware of the actual condition of the European economies. The ECB governors and the president must have known that as soon as they made their knowledge public the likelihood that the currency markets would drive the euro down on their own was very high. Better to speak and wait than to try to force the issue.

There is a further complication to bank intervention that has evolved since the last successful bout in 2000. In the decade since much of the world’s spare FX reserves have gone to China and the oil producing countries. Without their cooperation it is doubtful another round of intervention would succeed.

There is also the quandary that for over a decade western governments have been accusing the Chinese of manipulating the yuan for trade advantage. It would be difficult and embarrassing for the same western governments to ask China to help them to manipulate their own currencies for exactly the same reason.

Central banks have not sworn off intervention in the currency markets but they have taken a more rational view of the ingredients for success. The economic and financial crisis simply did not provide the necessary conditions for successful intervention. Coordinated central bank intervention is waiting for a more auspicious moment. The dislike of the bankers for the volatility of the currency markets has not dissipated; they will be back.