Monetary Authorities' Involvement in the Forex Exchange Market

WHY AND HOW CENTRAL BANKS MANIPULATE THE FOREX MARKET

Sometimes, central banks need to take action in the forex market to protect their national currency’s value. They can do this by buying or selling foreign currencies as reserves or by simply stating that a certain currency is too high or too low, letting the forex market participants adjust accordingly. This article explores the various kinds of central bank interventions and important facts to remember before trading.

WHAT IS FOREIGN EXCHANGE INTERVENTION?

Central banks can intervene in the forex market by buying or selling foreign currency to stabilize or adjust the exchange rate. This is usually followed by a change in the money supply by the central bank to avoid any unwanted effects on the local economy.

This method is called “sterilized intervention” and will be explained later, along with other ways of intervening in the currency market.

HOW FOREX TRADERS CAN TRADE A CENTRAL BANK INTERVENTION?

When the forex market moves very fast because of central bank intervention, traders need to be careful about their risk and reward, and use good risk management.

Central banks intervene in the forex market when they want the exchange rate to be different from the current trend. So, trading around central bank intervention is similar to trading reversals.

Also, the forex market often expects central bank intervention and moves against the long-term trend before it happens. Since this is not certain, traders can wait for the new trend to show up before entering a trade.

WHY DO CENTRAL BANKS INTERVENE IN THE FOREIGN EXCHANGE MARKET?

Central banks usually intervene in the forex market to boost the economy or keep a certain exchange rate. Central banks often sell local currency and buy foreign currency if the local currency becomes too strong and makes domestic exports more costly to foreign countries. So, central banks deliberately change the exchange rate to help the local economy.

Here is an example of successful central bank intervention to weaken the Japanese Yen against the US dollar. The Bank of Japan thought that the exchange rate was not favorable and quickly intervened to lower the Yen, which made the USD/JPY pair go up. The intervention happened in the time period shown by the blue circle and the effect was seen soon after.

Although central bank interventions typically yield positive outcomes, there are occasions when such efforts prove ineffective. The presented graph illustrates a case of currency intervention within the USD/BRL (Brazilian Real) currency pair. The chart underscores two specific occurrences in which the central bank interceded to halt the depreciation of the Brazilian Real. Evidently, both of these instances faltered in promptly revitalizing the Real's value vis-à-vis the US dollar, as the dollar incessantly surged to even loftier heights.

UNDERSTANDING CURRENCY INTERVENTION METHODS

Central banks possess a range of options when engaging in currency intervention, employing either direct or indirect strategies. Direct interventions exert swift and observable impacts on the foreign exchange (forex) market, whereas indirect interventions accomplish central bank goals through less overt approaches. Presented below are illustrations of both direct and indirect currency intervention techniques:

TYPES OF INTERVENTION	DIRECT OR INDIRECT
Jawboning	Indirect
Operational Intervention	Direct
Concerted Intervention	Direct and indirect
Sterilized Intervention	Direct

Operational Intercession: This is typically what individuals imply when referencing central bank intercession. It encompasses the central bank's acquisition and dispensation of both foreign and domestic currency with the intention of propelling the exchange rate to a predetermined level. It is the sheer magnitude of these dealings that sets the market in motion.

Jawboning: This constitutes an instance of indirect foreign exchange (FX) intervention, wherein a central bank hints at the possibility of intervening in the market if the local currency hits a certain undesirable threshold. This technique, as the name implies, hinges more on dialogue than actual intervention. With the central bank poised to intercede, traders collectively take it upon themselves to steer the currency back to more agreeable levels.

Concerted Intercession: This amalgamates jawboning and operational intervention, displaying its utmost efficacy when multiple central banks voice shared concerns regarding exchange rates. Should a multitude of central banks amplify their jawboning endeavors, it is plausible that one among them will indeed execute operational intervention to steer the exchange rate toward the sought-after direction.

Sterilized Mediation: Sterilized mediation encompasses two maneuvers executed by the central bank to sway the exchange rate while simultaneously keeping the monetary base unaltered. This involves a dual process: the vending or acquisition of foreign currency, coupled with an open market operation (selling or procuring government securities) of equivalent magnitude to the initial transaction.

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