1.    Introduction

Our purposes for this paper are to first answer the question of whether the signaling and intervention activities of AEs’ central banks still have economic relevance and, if so, whether any new channels of intervention have emerged in the aftermath of the financial crisis, especially in the context of unorthodox monetary policy. Our main targets are the large economies’ central banks and, in particular, the main advanced economies’ central banks. Lastly, our paper provides useful information for academic and policy debates regarding what the ‘best’ intervention policy might be and how to improve communication strategies between central banks and market stakeholders. The remainder of the paper proceeds as follows: Section 2 describes the dataset and the empirical research design. Section 3 presents possible empirical analysis, and Section 4 presents our key findings. Section 5 concludes.

Definitions Croce used a large subsample of major central banks. He identified the three foreign exchange market intervention points: 1) intervention facilities, 2) intervention announcements, and 3) actual intervention operations. The chosen threshold was driven by economic theory and policy practice. The facility point is the easiest case to document and the most common intervention shown in the data. The central bank announces that it will be willing to intervene at a publicly known price. Despite this event being entirely predictable, evidence shows that it still has informative content with implications for the foreign exchange market. The announcement point is the day on which an official representative of the central bank (or another public authority, for example, the Secretary of the Treasury in the Finance Minister in other countries) makes an official public statement that the public deems to refer to foreign exchange.

2.Historical Background of Central Banks in Forex Markets

Another critique, associated with the function of acting as a lender of last resort, has contemporary relevance in that the smoothing of exchange rate “sharp” movements, via the use of foreign exchange intervention or higher interest rates, could have unwanted speculative implications. According to Keynes (1924), the policy of earmarking preservation in favor of gold standard convertibility could not secure important currency exchange-rate equilibrium in the new postwar period. It reinforced the policies of isolation that led other countries to liquidate their shares of the other countries’ currencies and hold the balances of the Anglo-French consortium. Sheep flocks and nations followed the currency leader instead of diversifying their reserves.

Foreign exchange market interventions by modern central banks were exceptional in the early nineteenth century and were associated with efforts to return to some form of fixed exchange-rate standard. Before the nature of the classic gold standard’s working mechanism was fully understood, central banks’ procedures were repeatedly criticized. One main criticism was that the classical automatic adjustment process of the drain of international reserves (gold) from a central bank and contraction of the country’s money supply could not work quickly and effectively.

Many countries are not fully independent in terms of their monetary and foreign exchange policies, either due to specific obligations (e.g., under the Maastricht Treaty’s exchange-rate mechanism) or because of the composition of their foreign exchange reserves (usually denominated mostly in USD). In those countries, the central bank or treasury cannot really choose whatever composition of reserves they wish under the free-floating exchange rate system. However, notes Goodhart (2002), the history of money and the roles of central banks are not guided by any conception of national sovereignty.

3.Objectives of Central Banks in Forex Markets

The role of central banks in controlling the use of exchange rates is, however, questioned by several strains that emerged during the eighties and nineties in the rational expectation framework. Most of these are also based on the hypothesis of incomplete information and the microstructure motives of the agents. There is, however, a clear message in these works. Player central banks are unable to stabilize either the levels or the volatility of the exchange rates over time. This makes the cost of cooperation greater than the cost of non-cooperation. In a nutshell, stabilizing the exchange rates in a world with only central bank subscribers seems harmful.

Are the goals of the central banks and the objectives of the countries always in harmony? Of course, this is not an easy question to answer. It is widely believed that the primary objectives of the central bank are excessive monetary expansion. The aim is reflected in the desire to have lower levels of inflation, stable exchange rates, equilibrium external balances, and to achieve maximum growth in an economy without creating risks of inflation. In particular, the exchange rate is considered a fundamental factor that can be controlled by the central banks in order to calm their monetary policies. However, the objectives of the countries are largely influenced by the behavior of their main business counterparts. For instance, competitive growth strategies, external sector objectives, and political objectives finally collide with the goals of the central banks.

4.Tools and Instruments Used by Central Banks in Forex Markets

The operation used by the central banks to reclaim some of the reserves freed by intervention is known as “sterilization.” This consists of actions by the central bank that counterbalance the liquidity impact of foreign exchange market intervention. It is necessary to adjust the quantity of foreign currency that the bank might have to deal with to sterilize the operations that normally accompany such purchases or sales and which serve to ensure the continuity of the monetary policy conducted through interest rate variations. Sterilization may be carried out through the central bank’s normal market intervention operations, which can affect market liquidity, and/or by the bank’s recourse to standing facilities. Such an operation, thanks to its almost immediate nature, is crucial in monetary policy terms. Central bank operations on the foreign exchange market fulfill functions other than “short-term market management.” They can be carried out on the central bank’s own initiative or in response to pressure from the market. They can aim at a variety of market constraints, including meeting the needs of the general public or their own reserve management needs, which are largely unrelated to managing the bank’s counterparty risks. Furthermore, foreign exchange market operations are not always just aimed at raising or using up the euro balances of financial intermediaries. They are also conducted for solvency and signaling as well as profit-making reasons. The independent central bank has an interest in maintaining a presence in its monetary policy instruments through market operations that it drafts. These operations must be effective and immediate in terms of the operations’ communicating power, their impact on quantities, counterparty risks, counterparties’ access, unperturbed, and with clear attendant costs. Coordination has a role to play in defining the PI. On the one hand, the need to control its external value so that the changes in the exchange rate proper do not significantly interfere with the continuity of the achievement of the nominal objectives of monetary policy supports close cooperation between the monetary and financial authorities over the conditions of liquidity supply and the pursuit of the configuration of the financial market.

According to many central banks’ charters, foreign exchange market intervention, if carried out, should be announced publicly and be rather sporadic. A central bank’s intervention in the foreign exchange market is aimed at smoothing exchange rate fluctuations and not targeting exchange rate movements in one direction. In practice, there are still many capabilities of the central banks in the market because the central banks can create their own reserves and draw a limit. In order to carry out its functions, the central bank may have recourse to certain facilities and instruments for performing its currency intervention operations.

5.Impact of Central Bank Interventions in Forex Markets

One of the reasons that creates confusion about the operational side of the foreign exchange policy of some central banks is that they may have more than one objective. In other words, is the objective of the intervention to alter expectations about future monetary policy, or is it simply to nudge the exchange rate path away from the level found by observation of financial market trading? On the one hand, the use of foreign exchange intervention as a policy instrument may be seen as a ‘third way’. In other words, it can supplement both the use of domestic monetary policy and comprehensive public discussion. However, as soon as central banks adopt a more ‘ambitious’ objective aimed at moving the exchange rate, they take on a commitment that is far more difficult to reverse. And as central banks have access to relatively large financial resources, their intervention capacity is sufficiently large to influence the foreign exchange markets. Usually, central bank influence on the foreign exchange market is signaled, and on the strength of that signal, private participants adjust their positions. Such guidance is also a form of balance sheet expansion.

Central banks may intervene directly to influence their exchange rates, either by signaling that they want a depreciated exchange rate, by buying domestic or foreign currencies, or by changing monetary conditions. At the very least, central banks are keen to communicate their stance towards the exchange rate to ensure that markets do not have a totally different view from their own. In many cases, however, central banks are also prepared to demonstrate that their communication policies are backed up by action. Indeed, a major concern of central banks is to engender some uncertainty about the real stance of their policy objectives for the exchange rate. This is true of both the policy stance and the objective they consider optimum for their economy. It is an extremely complex and challenging exercise to integrate this objective with the management of monetary policy in general.