Managed Fixed Exchange Rates

Includes: FXE, UDN, UUP
by: Lok Sang Ho

Exchange rate regimes are said to fall into these categories: fixed, floating, and managed float. There are different ways of managing a "floating exchange rate," which is sometimes called "dirty float," as opposed to a clean float. "Managed fixed exchange rate" is my invention, and I believe for a good reason.

To understand the rationale behind and the substance of "managed fixed exchange rate," we need to look no further than Draghi's recent comment about the euro. He said that the euro's value should broadly reflect economic fundamentals and that while the exchange rate is not a policy target, it is important for growth and price stability.

Since economic fundamentals are not expected to suddenly change overnight, it makes sense to prevent the exchange rate from being driven off the fundamentals-compatible level by short-term capital flows, which everyone familiar with the forex market knows can be erratic and massive. This is why I argue that exchange rates should be kept stable at levels compatible with economic fundamentals ("fixed"), although should change with the economic fundamentals when data show that such fundamentals have changed.

The presumption behind managed fixed exchange rate is that exchange rates should be fixed at levels compatible with fundamentals but should be changed when fundamentals have changed.

This contrasts with the presumption behind the managed float: which is that exchange rates should be allowed to float - as if exchange rates based on free market forces were automatically justified by economic fundamentals. Floating exchange rates are to be prevented from excessive gyrations as if policy makers can tell what is excessive and what is not.

Unfortunately, this latter presumption behind floating exchange rate does not square with the reality. Often times, exchange rates are driven by market forces away from what is compatible with economic fundamentals. We have seen the "super dollar" prior to the Plaza Accord. We have seen how the strong yen ruined the Japanese economy. We have seen the strong euro kill the Euro economy.

There is nothing sacred about floating exchange rates. We all know that, though we sometimes pretend otherwise - when it suits our purpose.

Managed fixed exchange rate may be thought to be the same as the crawling peg. But whereas the crawling peg seldom makes reference to economic fundamentals, the proposed managed fixed exchange rate regime tries to fix the exchange rate at the level consistent with economic fundamentals. In order to do this, the reference peg should be relative to a basket of currencies rather than to a single currency. The "benchmark currency basket" consisting of the major currencies of the world weighted by the respective GDPs appears to be most appropriate, as a peg against the benchmark currency basket has been shown to be equivalent to fixing the nominal exchange rate. For countries whose inflation does not diverge noticeably from world inflation, fixing the nominal exchange rate against the benchmark basket is no different from fixing real effective exchange rates.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.