Does Verbal Intervention Work in FX Markets?
Posted by Colin Lambert. Last updated: August 31, 2021
As someone with a chequered relationship with the academic world, it was interesting to read a summary of a paper published last week in Empirical Economics that looks at the effectiveness of verbal intervention in FX markets by the Reserve Bank of Australia at the beginning of the 21st century.
The research creates an Exchange Rate Stance Index (ERSI) to measure the magnitude of the oral interventions and seeks to quantify the impact of RBA’s communication on the Australian dollar and overall economic activity.
It finds that an unanticipated increase in the ERSI leads to a significant weakening of the Australian dollar and considerably stimulates output. “The ERSI shocks account for a sizeable fraction of Australia’s macroeconomic fluctuations, comparable to the exchange rate shocks,” the authors state in a summary, adding, “The impact of ERSI on output is largely transmitted through the exchange rate depreciation.”
The paper further adds that the effectiveness of verbal interventions meant the RBA did not have to reach into its policy toolkit to achieve its desire for a lower Australian dollar.
So, oral interventions work and in this case the RBA’s desire for a lower exchange rate was satisfied, which, it was. But do they? Does coincidence play a role?
The first eight years of this century was characterised by a steadily rising Australian dollar (against the US dollar), which came to a shuddering halt as the GFC started to unfold, headlined by the collapse of Lehman Brothers. Even then though, the Aussie never plumbed the depths of 2001-02 and the movement was clearly the result of a flight to quality, in this case the US dollar.
Not being a stranger to contesting academic findings on FX markets, I feel impelled to raise the ante with the example of “Mr Yen”, Eisuke Sakakibara, who was vice minister for international affairs in Japan’s Ministry of Finance. Sakakibara earned the moniker “Mr Yen” after his repeated warnings over yen weakness were realised in late 1998 as USD/JPY collapsed from above 140 to 110 in a matter of weeks, and continued falling.
Putting aside the irony in the modern world of Japan seeking a stronger yen, the intervention was not only verbal, there were plenty of dollars sold by the Bank of Japan on the way up as well, but Sakakibara started warning about yen weakness when USD/JPY was trading around 110. It rose to above 140, and then came all the way back down.
The net result of following “Mr Yen’s” example would have relied, therefore, upon the carry and required a stop loss of staggering lenience!
The point is that often foreign exchange rates reflect fundamentals, it’s just the fundamentals might be somewhat different to classic economic thinking – for example, risk on/off. Going back to the RBA example in the recent paper, the central bank can communicate its thinking, indeed should, and often, assuming its economic outlook is right, the exchange rate will move in the desired direction. Again though, in 2010-11, there was a desire to see a lower Aussie dollar, but it continued higher, peaking just shy of 1.10.
The experience of history offers an interesting insight into central bank activity in FX markets – the general sense is that actual intervention can be effective, if it is a surprise in terms of the timing and, if it is coordinated. I may be wrong on this, but if I recall rightly, the collapse in USD/JPY was triggered by a very rare instance of the US intervening in markets to sell the dollar. Thus, it was the shock of the US intervention with the Bank of Japan that prompted the fall, not the utterings of a government official.
(A long way) back in the day, intervention by individual central banks could work, but rarely for an extended period of time. In the 1980s coordinated intervention worked, but even a behemoth like the Bundesbank found intervening “against the wind” could be a futile exercise.
While verbal intervention can perhaps take some of the “froth” off an overdone currency move, I remain sceptical that without policy actions or a sustained shift in economic fundamentals, it can influence markets to any great degree. That said, the central bank has to continue communicating its viewpoint – my scepticism is not over this, it is the suggestion that traders following such narrative will make money.
My sense is that the data in this study conveniently reflected the narrative, but for a trader or investor, there would have been a tremendous amount of pain following the central bank lead in the UK, Japan and even Australia. The official position when Sterling exited the ERM was that it would not do so…right up to the minute the announcement to leave was made.
More pertinently for modern day traders, there is a great example of where what a central bank said, and what it was able to achieve (at a cost of billions of euros), differed remarkably and resulted in one, if not theworst blow out in foreign exchange history. Swiss National Bank anyone?