FX Interventions and Inflation Targeting 10 May 2016 Tomáš Holub International Macroeconomics

Outline FX interventions in the IT literature vs. actual practice Proposals of managed floating and some limitations Czech experience in normal times FX interventions as an unconventional tool Conclusions 2

Outline FX interventions in the IT literature vs. actual practice Proposals of managed floating and some limitations Czech experience in normal times FX interventions as an unconventional tool Conclusions 3

Assumption of perfect capital mobility and arbitrage (UIP): i =domestic interest rate, i* = foreign IR, E(e) = expected depreciation,  = risk premium) FX interventions: could have an some impact through expectations or the risk premium; Montoro, Ortiz (2013); Malovaná (2015): modified UIP with FX dealers, in which risk premium depends on CB‘s interventions: However, the standard IT theory assumes (and recommends) pure floating, no role for ER management; Monetary policy effects the ER through IR; IR changes in response to changes in inflation forecast. IT Theory Gives Little Guidance on Interventions 4

An increase in the number of floating ERs; But “fear of floating” in small open economies (Calvo, Reinhart, 2000); Many central banks do intervene in practice; Newcomers to the club often do manage the ER; New Zealand: changed policy from free floating to using interventions; Interventions more frequent during the recent crisis. Fear of Floating 5

FX Interventions in IT Practice (i) According to IMF‘s classification, (managed) floating now dominates among IT countries. 6

FX Interventions in IT Practice (ii) Moreover, even some of the free floaters do actually intervene at least occasionally. 7

Brazil: in Oct 2008 established a discount window and loans in FX, direct FX interventions, FX auctions to exporters; Chile: on 2 Jan 2011 decided to start a program of foreign currency purchases aimed at strengthening its international liquidity position and smoothing the effects of ER adjustment; Indonesia: increasing net FX assets in recent past, but a substantial drop during the crisis in 2008 (esp. in Oct 08). Imposed some restrictions on FX dealings in Nov 2008; Israel: FX interventions in as part of unconventional policy (originally motivated by the desire to increase FX reserves); Mexico: Sold a total of USD 16.2 bn. directly to the FX market during 2009; several programs of regular auctions, discontinued in New Zealand: 1st used its new intervention mandate in 2007; Poland: an interventions to weaken zloty on 9 Apr 2010; interventions to support zloty from Sep do Dec. 2011; South Korea: aggressive interventions during the crisis in 2008 (in Oct 2008 alone, the FX reserves fell by USD 24.7 bn.; further interventions in early March 2009; Switzerland: Interventions against CHF started on 12 March 2009; Sep 2011 – Jan 2015 a floor at 1.20 CHF/EUR. Interventions during the Crisis 8

A New Post-Crisis Paradigm for the EMEs? Source: Source: Blanchard (2011); 9

Outline FX interventions in the IT literature vs. actual practice Proposals of managed floating and some limitations Czech experience in normal times FX interventions as an unconventional tool Conclusions 10

How Could Managed Floating Help? Suggestions of managed floating: – Bofinger, Wollmers- haeuser, (2001; 2002); – Goldstein (2002): „Managed floating plus“ If the CB was able to reduce excess ER volatility by managing the ER float, it could achieve a better trade- off between inflation and output variability. But: can it be achieved (without harming credibility)? 11

Transmission Channels of FX Interventions to the Exchange Rate Market channel Portfolio balance channel (Branson; Kouri; 1976)  Effectiveness depends on size Signalling (expectations) channel (Musa, 1981)  Effectiveness depends on information and credibility Noise-trading (+coordination) channel Order- flow channel (Lyons, 1997; Peires, 1997)  Effectiveness depends on market microstructure and information transmission 12

Effectiveness of Interventions (Cavusoglu, 2010) „Interventions have been found to have a significant short term effect on exchange rates (up to 3 Ms) through the signaling and coordination channels, i.e. by providing the market with information about future policies and macroeconomic fundamentals and by coordination of expectations.“ 13

Consistency with the IT Regime (e.g. Geršl, Holub; 2006) Target consistency  Are interventions not running against the goals of inflation targeting? (e.g. in Hungary) Regime consistency  Are IRs used as the main MP tool, interventions only supplementary?  Are the goals of ER management not in conflict with IR policy (UIP condition – trying to „restore“ it, not work against it)? Procedural consistency  Do interventions follow clear procedural rules and communication standards? 14

Target Consistency (Hungarian Case) In certain periods, the ER band was inconsistent with the need to tighten monetary policy. Credibility is hard to gain, but easy to loose. 15

Transparency of FX Interventions Many ITers are still quite opaque concerning their FX operations (in terms of preferences, strategy, decisions taken, ex post evaluation, etc.); This is not fully consistent with the generally high degree of transparency under the IT regime. 16

Outline FX interventions in the IT literature vs. actual practice Proposals of managed floating and some limitations Czech experience in normal times FX interventions as an unconventional tool Conclusions 17

CNB‘s FX Interventions Relatively long periods of no interventions; Interventions against appreciation only; February-July 1998; October 1999-March 2000; ; Since 2002 no interventions. 18

Effectiveness – Summary of Results Disyatat, Galati (2005): Intervention had some (weakly) statistically significant impact on the spot rate and the risk reversal but that this impact was small. No evidence that intervention had an influence on short-term exchange rate volatility. Geršl, Holub (2006): Interventions have probably played a minor role in influencing the short-run ER development at best. They contributed to an increased volatility of the ER, but only to a limited extent. Geršl (2006): The results indicate that interventions by the CNB had only small short-term effect on exchange rate level and to a certain extent contributed to the increased conditional and implied volatility. Égert, Komárek (2006): From mid-1998 to 2002, interventions turn out to be (more) successful in reversing the appreciation trend in the short run and in smoothing the exchange rate at longer horizons up to 60 days. The econometric evidence indicates that koruna sales have a positive relationship with the exchange rate from mid-1998 to

Consistency with the Inflation Targeting (CNB‘s Case) 20

Outline FX interventions in the IT literature vs. actual practice Proposals of managed floating and some limitations Czech experience in normal times FX interventions as an unconventional tool Conclusions 21

FX Interventions and UMP (i) Proposed already for Japan by Mc Callum (2000) ; Svensson (2001): “Monetary policy with a zero interest rate“ – The exchange rate as a policy instrument – "The Foolproof Way" to escape a liquidity trap (more on this at the seminar); May be more effective than the other quantitative easing tools (direct exchange rate channel, indirect exchange rate channel, inflation expectations channel); Is consistent with the IT logic (aimed at achieving the targets, no further IR cuts possible, may be transparent); Counter-argument: beggar-thy-neighbour policy (?); Practical experience: (Israel ?); Switzerland, Czech Republic (seminar topic). 22

”(13 Mar 2008) The Bank of Israel advises that in light of the unusual movements in the shekel exchange rate in the last few days, the Bank today purchased foreign currency in the market.“ ”(20 Mar 2008) The Bank of Israel announces plan to increase foreign exchange reserves by 10 billion dollars over the next two years by purchasing approximately 25 million dollars per day in the market, beginning 24/3/08.“ ”(10 Jul 2008) The Bank of Israel announced that as of today, it will increase the average daily rate of foreign currency purchases to 100 million dollars.“ FX Interventions and UMP (ii) 23

12 March 2009: „the Swiss National Bank (SNB) announced that it would take forceful action to ease monetary conditions. It decided to make another interest rate cut and act to prevent any further appreciation of the CHF against the euro. To this end, the SNB will increase liquidity substantially by engaging in additional repo operations, buying CHF bonds issued by private sector borrowers and purchasing foreign currency on the FX markets.“ August 2011: the SNB narrowed the key interest rate range from 0.00–0.75 p.p. to 0.00–0.25 p.p. and sharply increased the supply of liquidity. September 2011: the SNB set a minimum exchange rate of 1.20 CHF/EUR, stating that it would buy foreign currency in unlimited quantities if the rate fell below this level. FX Interventions and UMP (iii) 24

Sheqel depreciated temporarily (in line with other currencies); CHF/EUR stayed above 1.50 till late-2009, but then appreciated again, until the floor at 1.20 was announced. FX Interventions and UMP (iv) 25

Substantial increase in FX reserves, especially in Switzerland (see also the next slide for an update). FX Interventions and UMP (v) 26

The SBN‘s floor on the CHF/EUR exchange rate was successfully maintained for more than 3 years, but the FX reserves had to increase significantly in some periods. The exit on 15 January 2015 was totally unexpected, abrupt and shock-generating. FX Interventions and UMP (vi) 27

Outline FX interventions in the IT literature vs. actual practice Proposals of managed floating and some limitations Czech experience in normal times FX interventions as an unconventional tool Conclusions 28

Conclusions (i) Standard IT literature gives little guidance on FX interventions; Some proposals to combine IT with managed float; In practice, many inflation targeters do use interventions (increased use during the crisis); IT regime in CZ since 1998 combined with managed float; Three periods of FX interventions against CZK between 1998 and 2002; Empirical evidence on effectiveness of standard interventions is mixed at best; Not easy to combine IT with managed float in a consistent way. 29

Conclusions (ii) Larger economies thus probably better of with freely floating exchange rate under the inflation targeting regime in normal circumstances; Even in small open economies, interventions should be relatively rare under the inflation targeting regime, and be viewed at best as a supplementary monetary policy tool; Interventions should be avoided especially in those circumstances, when they would go against future fulfilment of the inflation targets, would push the exchange rate away from equilibrium, and when interest rates could be adjusted in the first instance; But, at the ZLB the exchange rate can actually become an effective (temporary) instrument of monetary policy. 30

Thank you for your attention. 31