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Felix Hiifner Foreign Exchange Intervention as a Monetary Policy Instrument Evidence for Inflation Targeting Countries With 32 Figures and 23 Tables ZEW Zentrum for Europăische Springer -Verlag Berlin Heidel berg GmbH Wirtschaftsforschung GmbH Centre for European Economic Research
Series Editor Prof. Dr. Wolfgang Franz Author Dr. Felix Hiifner Centre for European Economic Research (ZEW) L7, 1 68161 Mannheim Germany ISBN 978-3-7908-0128-6 ISBN 978-3-7908-2672-2 (ebook) DOI 10.1007/978-3-7908-2672-2 Cataloging-in-Publication Data applied for A catalog record for this book is available from the Library of Congress. Bibliographic information published by Die Deutsche Bibliothek Die Deutsche Bibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data is available in the Internet at <http://dnb.ddb.de>. This work is subject to copyright. AII rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilm or in any other way, and storage in data banks. Duplication of this publication or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permission for use must always be obtained from Physica-Verlag. Violations are liable for prosecution under the German Copyright Law. springeronline.com Springer-VerlagBerlinHeidelberg 2004 Originally published by Physica-Verlag Heidelberg in 2004 The use of general descriptive names, registered names, trademarks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. Cover design: Erich Dichiser, ZEW, Mannheim SPIN 10957905 88/3130-5 4 3 2 1 O - Printed on acid-free paper
Preface This book was written while I was a PhD student at University ofwiirzburg and a research fellow at the Zentrum fur Europaische Wirtschaftsforschung (ZEW) (Centre for European Economic Research) in Mannheim. It was accepted as a doctoral dissertation in March 2003 under the title "Sterilized Foreign Exchange Intervention as a Monetary Policy Instrument in Inflation Targeting Countries Evidence for Australia, Canada, New Zealand, Sweden and the United Kingdom ", I owe a particular debt of gratitude to my supervisor, Professor Peter Bofinger, for his steady support and many helpful discussions. I would also like to thank my second advisor, Professor Martin Kukuk. Furthermore, I would like to thank the ZEW and in particular Professor Wolfgang Franz for supporting this dissertation. During the preparation of this book I benefited from fruitful discussions with my colleagues, Friedrich Heinemann, Volker Kleff, Jens Koke, Matthias Meitner, Michael Schroder and Martin Schuler from the ZEW financial markets department. Furthermore, I received many helpful comments from participants of the doctoral seminars in Wiirzburg. In particular, I would like to thank Timo Wollmershauser from University of Wiirzburg for several comments and suggestions. Finally, I would like to thank my parents, my brother Max as well as Sandra for their support and encouragement over the past years. Mannheim, June 2003 Felix Hiifner
Table of Contents 1 Introduction............................................. 1 1.1 Background 1 1.2 Approach to the Problem and Research Strategy 3 1.3 Structure of the Analysis 6 2 The Conventional View on Inflation Targeting 7 2.1 Definition and Elements oflnflation Targeting 7 2.1.1 Lack of an Explicit Intermediate Target... 8 2.1.2 Price Stability as the Final Target 12 2.1.3 Publication of a Numerical Target.. 13 2.1.4 Transparent Communication of Central Bank Decisions 15 2.1.5 Increased Accountability of the Central Bank 16 2.1.6 Summary and Assessment.. 16 2.2 Adoption oflnflation Targeting 17 2.2.1 Overview 17 2.2.2 Country Selection 18 2.3 A Basic Model for (Closed-Economy) Inflation Targeting 21 2.4 Open Economy Inflation Targeting 23 2.4.1 Exchange Rate Pass-Through and Monetary Policy 24 2.4.2 The Svensson Model 27 2.4.3 The Ball Model. 28 2.4.4 Two Critical Assumptions 30 3 Uncovered Interest Parity in Practice................ 33 3.1 The Rationale ofinterest Parity 33 3.1.1 Covered Interest Parity 33 3.1.2 Uncovered Interest Parity 34 3.2 An Empirical Test for Inflation Targeting Countries 36 3.3 Consequences of the Failure ofuip 42 4 Sterilised Interventions as an Additional Policy Instrument... 45 4.1 Explaining and Interpreting Sterilised Interventions 45 4.1.1 Channels for Influencing Exchange Rates 45 4.1.2 Sterilised Interventions as a Monetary Policy Instrument 48 4.1.3 Sterilisation Evidence for Inflation Targeting Countries 52 4.1.4 Managed Floating in Theory 54
VIII Table of Contents 4.1.5 Limitations ofsterilised Interventions 58 4.2 The Effectiveness ofsterilised Interventions: A Review ofthe Literature 59 4.2.1 The Intervention Debate 59 4.2.2 The Inefficiency ofsterilised Interventions in Monetary 4.2.3 4.2.4 4.2.5 4.2.6 4.2.7 Models 61 The Portfolio Balance Channel ofinterventions 62 Interventions as a Signal of Future Monetary Policy 64 Noise-Traders and the Role ofsterilised Interventions 68 The Microstructure Approach and Sterilised Interventions 71 Assessment ofintervention Models 76 5 Sterilised Foreign Exchange Intervention in Practice 79 5.1 Foreign Exchange Reserves as an Intervention Proxy 80 5.1.1 Reasons for Holding Foreign Exchange Reserves 82 5.1.2 Mechanics offoreign Exchange Intervention 84 5.1.3 External Influences on Foreign Exchange Reserves and Their Adjustment 87 5.1.3.1 Identification and Correction of Valuation Effects 87 5.1.3.2 Estimation ofinterest Earnings 88 5.1.4 The Correlation between Official Interventions and Reserves 89 5.1.5 Active versus Passive Interventions 91 5.2 Intervention Activity in Inflation Targeting Countries 93 5.2.1 Comparison ofintervention Capacities 93 5.2.2 Comparison ofreserve Changes 95 5.2.2.1 Correction for Valuation Changes 95 5.2.2.2 Correction for Interest Earnings 96 5.2.3 Identification ofintervention Activity 97 5.2.3.1 Absolute Reserve Changes 98 5.2.3.2 Normalisation with the Degree ofopenness 98 5.2.3.3 Normalisation with the Size offoreign Exchange Markets 99 5.2.3.4 Response to Shocks 100 5.2.4 Ranking ofintervention Activity 101 5.3 The Use ofinterventions as an Additional Policy Instrument 107 5.3.1 Interventions and the Variation ofinterest Rates 109 5.3.1.1 Interest Rate Volatility Compared 109 5.3.1.2 Frequency ofpolicy Rate Changes Compared 110 5.3.1.3 Interpretation ofthe Findings 111 5.3.2 Policy Reaction Functions and Exchange Rates 112 5.3.2.1 Evolution oftaylor Rules 112 5.3.2.2 Description ofdata and Methods 114 5.3.2.3 Stationarity Tests 116 5.3.2.4 Country-Specific Results and Interpretation 117 5.4 Short Case Studies ofthe Country Experiences 122 5.4.1 New Zealand 123 5.4.2 Canada 127
Table of Contents IX 5.4.3 Australia 131 5.4.4 United Kingdom 135 5.4.5 Sweden 140 6 Performance of Inflation Targeting: An Evaluation 145 7 Conclusion and Outlook....................151 Appendix................................ 155 List of Figures 163 List of Tables....................................... 165 Bibliography................................... 167