Is a Revival of U.S. Currency Market Intervention Coming?
January 26, 2017
I suspect it is. Foreign exchange intervention used to be a key tool of monetary policy, wherein countries buy or sell their own currency in the marketplace against a different widely traded currency. As such, FX operations are like the open market operations used to guide banking reserves and domestic monetary policy, but there’s a catch. U.S. intervention historically has almost always been sterilized, which means that after buying or selling another country’s currency, the Federal Open Market Desk does an offsetting Treasury market transaction to neutralize the effect on banking reserves. Another catch is that while domestic monetary policy is managed by a central bank with legally mandated independence from politicians, primary responsibility for dollar policy rests with the Secretary of Treasurer, who is accountable to the president and works at his pleasure.
The idea behind intervention is to shift the market clearing price for one’s currency by directly augmenting or reducing net supply and, equally important, by affecting the expectations of currency market participants regarding the future trend. In the fixed exchange rate era, intervention was a means for limiting dollar movement to narrow pre-announced trading bands. After the dollar was cut loose from such constraints in March 1973, the tendency for one-sided dollar risk in market conditions that lacked breadth, depth, and resiliency compelled U.S. authorities in July 1973 to redefine a role for intervention. Countering disorderly market conditions is invariably the reason used to justify the use of intervention. However, oftentimes, an exchange rate that officials perceive to be inconsistent with comparative economic fundamentals plays a role in triggering intervention, particularly when exchange rates are undermining major economic policy priorities like reducing a trade imbalance, promoting growth or changing the rate of inflation.
U.S. intervention fell out of favor in the early 1980s and more enduringly in the middle of the 1990s. The first abandonment of intervention in Ronald Reagan’s first term reflected a ideological shift at the Treasury Department that embraced market-determined prices and away from any artificial manipulation of market forces by the government. The second abandonment stemmed from mounting skepticism about the effectiveness of intervention as a policy tool. A considerable body of empirical research found that intervention at best only worked well when coordinated with other governments, supplemented by other policy changes consistent with the desired aim of the intervention, and when currency rates are truly misaligned with prevailing economic fundamentals.
Intervention was used quite extensively in the 1970s. The Carter Administration’s dollar rescue effort in November 1978 assembled considerable resources to fund intervention but also included an unprecedented full-percentage point hike in its short-term interest rate. Other flurries of intervention occurred around the September 1985 Plaza Accord and in March 1987 when U.S. officials felt that the dollar had fallen far enough. 1989 saw the United States do about $22 billion of intervention combined vis-a-vis the German mark and Japanese yen, which surpassed all the intervention during the prior four years.
The last four instances when the United States intervened in the currency markets happened in 1995, 1998, 2000 and 2011. About $3.6 billion was purchased in total against marks and yen in the second quarter of 1995 to back up improving U.S. fundamentals and expressions by Treasury Secretary Rubin that a strong dollar is in the economy’s best interest. On June 17, 1998, the U.S. in concert with other central banks sold less than $1 billion against the yen. On September 22, 2ooo, the Fed as part of an operation shared with the ECB, BOJ, Bank of Canada and Bank of England bought $1.5 billion of euros at a time when the youthful single European currency was struggling. And the last use of intervention came on March 10, 2011 when $1 billion equivalent of yen were purchased in the aftermath of a devastating earthquake in Japan. That operation, like the one in September 2000, was highly coordinated with other countries.
Here’s why I think the Trump Administration may resort to intervention this year. A bunch of policy changes seem likely to lift the dollar, like tighter Fed policy, a bigger federal deficit from tax cuts and more spending, financial market deregulation, and trade protectionism. A rising dollar, however, could undermine the goals of the other policy initiatives. Intervention fell out of favor during the past two decades as a result of a lot of academic literature, but the new administration has been looking elsewhere for truth and isn’t predisposed to large multilateral policy efforts. The new policymakers almost certainly would actually prefer unilateral intervention to coordinated intervention. Tactically, too, intervention is like a tweet in the middle of the night. The short-term effectiveness derives from catching market participants with big currency exposures by surprise from an unscheduled development.
A strengthening dollar poses a huge threat to the new president’s ambition to make American manufacturing more muscular. The desired effects of all the other planned policy changes is not going to be allowed without a fight to be undone by dollar appreciation. Intervention comes in two flavors. Soft intervention works through verbal threats that such operations are being considered. If the dollar continues to rise, however, actual intervention is likely to be used.
Getting the timing right on this kind of thing is difficult, but history suggests sooner rather than later. Not to put too fine a point on it, it doesn’t seem mere coincidence that the heavily increased incidence of intervention in 1989 happened in the first year of a new president. The Plaza Summit in 1985 occurred after a big shake-up in the U.S. Treasury Department leadership at the start of Reagan’s second term. The abandonment of fixed dollar rates transpired at the start of Nixon’s second term in office, and other new presidents like Carter in 1977 and Clinton in 1993 appointed advisers who wasted little time complaining that an overvalued dollar was putting strain on the U.S. trade balance.
Copyright 2017, Larry Greenberg. All rights reserved. No secondary distribution without express permission.
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