Exchange-Rate Swings and Foreign Currency Intervention

IMF Working Papers, July 29, 2022

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Develops a new approach for exploring the effectiveness of foreign currency intervention, focusing on real exchange cycles.
Uses band spectrum regression methods to examine the role of macroeconomic fundamentals in determining the equilibrium real exchange rate at short-, medium-, and low frequencies.
Assesses the effectiveness of FX intervention depending on the degree of cycle-specific misalignments for 26 advanced- and emerging market economies, covering the period 1990–2018, and uses different techniques to mitigate endogeneity concerns.

Evidence supports the hypothesis that central banks can lean effectively against short-run cyclical misalignments of the real exchange rate.
The effects are present in quarterly data—i.e., at policy-relevant horizons.
The effectiveness of intervention rises with the size of the misalignment.
Effectiveness also rises with the duration of one-sided interventions.
FX sales appear to be somewhat more effective than FX purchases.
Intervention is less effective in more liquid FX markets.

Core estimation technique: band spectrum regression methods to separate short-, medium-, and low-frequency components of real exchange rates and fundamentals.
Sample: 26 advanced- and emerging market economies.
Sample period: 1990–2018.
Data frequency: quarterly.

Central banks can influence short-run cyclical real exchange rate misalignments through FX intervention at horizons relevant for policy (quarterly).
Greater impact is expected when interventions are:
- Larger in size (effectiveness rises with the size of the misalignment).
- Sustained and one-sided in duration.
Consideration should be given to market liquidity conditions, as higher FX market liquidity is associated with reduced intervention effectiveness.
Net FX sales may be prioritized over FX purchases when policy aims to lean against appreciation pressures, given the evidence of somewhat greater effectiveness.