Central Bank Intervention Research Articles

Central Bank Policy Impacts on the Distribution of State Prices for Future Interest Rates, 2003–2022

In this article, we extend the 1978 Breeden–Litzenberger method of extracting state prices from option prices, showing how portfolios of butterfly spreads can be combined with right and left tail spreads to nonparametrically extract discrete state prices from option prices. We derive how those state prices should be biased estimates of true, objective probabilities. For interest rate options, we show that the biases can vary predictably over time (sometimes too high, sometimes too low), as the correlation of interest rates with consumption and wealth has changed signs over time. Consumption betas and proper risk premiums on bonds and of their state prices are at times predictably positive and at times predictably negative. We apply our technique to provide a brief 20-year history of central bank intervention impacts in the US, UK, and Eurozone from 2003 to 2022. Movements in state prices are quite large in the Financial Panic of 2008–2009, as well as in the European Sovereign Debt Crisis of 2010–2013, with Brexit and the Trump elections in 2016, and with the coronavirus pandemic in 2020–2021. Tapering in 2013 and 2022 and liftoffs in rates in 2015 and 2022 were shown to strongly shift state price distributions back toward the symmetry of 2003–2007. We show that central banks dramatically impacted entire state price distributions, not just levels of rates.

Target Date Funds, Drawdown Risk, and Central Bank Intervention: Evidence during the COVID-19 Pandemic

Target Date Funds (TDFs) have become the default investment choice in retirement accounts for most households. Later-dated TDFs (e.g., further away from the present day) allocate a more significant percentage of each dollar invested into equities relative to fixed income. As the TDF moves closer to the designated retirement date, the TDF embarks on its’ glide path. We study the impact of the COVID-19 Pandemic and Federal Reserve intervention on the max drawdowns experienced by TDFs during 2020. Later-dated funds experienced more significant drawdowns relative to near-dated funds. Moving out one target date fund increased the drawdown by approximately 1.90%. Approximately 80% of TDFs experienced their max drawdown on 23 March 2020. The max drawdowns of the TDFs are then studied in the following three sub-periods: (1) before the first Federal Reserve Intervention (2 March 2020), (2) after the first intervention and before the second intervention (16 March 2020), and (3) the period after the second intervention. TDFs experienced the greatest drawdowns after the first intervention by the Federal Reserve (approximately 19%) relative to the other two periods (approximately 7%). Fees associated with the TDFs tend not to influence the drawdowns except for the near-dated funds, where the low-fee funds performed better. Finally, near-dated funds recovered from their max drawdowns around September 2020, whereas later-dated funds did not fully recover until December 2020.

Stabilization of Stochastic Exchange Rate Dynamics Under Central Bank Intervention Using Neuronets

The exchange rate dynamics affect national economies because fluctuations in currency prices distort their economic activity. To maintain an optimal exchange rate policy, these dynamics are crucial for countries with a trade economy. Due to the difficulty in predicting the participants behavior in some complex economic systems, which might throw the system into chaos, a novel stochastic exchange rate dynamics (SERD) model is introduced and investigated in this paper. Furthermore, a neural network approach is proposed and examined as a control chaos method to address the problem of stabilizing SERD through central bank interventions. Derived from power activation feed-forward neuronets, a 2-input weights-and-structure-determination-based neuronet (2I-WASDBN) model for controlling chaos in SERD under central bank intervention is presented in this paper. Six simulation experiments on stabilizing the chaotic behavior of the SERD model show that the 2I-WASDBN model outperforms other well-performing neural network models and that it is more effective than traditional methods for controlling chaos. By examining the volume of necessary intervention predicted by the 2I-WASDBN model, central banks can better comprehend exchange rate fluctuations and, in conjunction with their monetary policies, can make more precise decisions regarding the strategy of their interventions.

Determinants of Foreign Exchange Rate of Selected Developing Countries: A Conceptual Review

Foreign exchange rate is often seen as an important factor that influences country’s level of productivity, employment rate as well as international trade. Therefore, constant fluctuation in currencies exchange rate has been a major concern in international business operation across countries of the world. This study focused on reviewing the determinants of foreign exchange rate from studies conducted in some developing countries of the world based on literature mapping approach between 1994 to 2020. The study concludes that trade, money supply, trade openness, domestic investment, interest rate differentials, foreign exchange, productivity, inflation, capital inflow, gross domestic production, current account balance, external debt, government spending, oil revenue, nominal exchange rate, price of gold, tariffs, investments, central bank intervention, foreign asset and net export were considered as determinants of foreign exchange rate in some the developing countries of the world.

Investment in Cryptocurrencies

Technology has created a significant difference in the lives of the people due to paradigm shift from offline activities to online activities. Cryptocurrency is a digital coin money based on the concept of cryptography encryption and electronic connectivity to function. Cryptocurrency is one of the best inventions in the context of financial sector. Being a decentralised currency, it also opposes the intervention of central banks and digital currencies by them. It transforms the virtual trade market by introducing a free rein trading mechanism that operates without the involvement and regulation of a third party. Digital currencies in today’s scenario become need of the hour thus this paper compares the most prevalent cryptocurrencies of India on the basis of market capitalization rate. The paper also aims to study the key characteristics of the digital currencies.

Monetary policy in an oil-dependent economy in the presence of multiple shocks

Russian monetary policy has been challenged by large and continuous private capital outflows and a sharp drop in oil prices during 2014. Both contributed to significant depreciation pressures on the ruble and led the central bank to give up its exchange rate management strategy. Against this background, this work estimates a small open economy model for Russia, featuring an oil price sector and extended by a specification of the foreign exchange market to correctly account for systematic central bank interventions. We find that shocks to the oil price and private capital flows substantially affect domestic variables such as inflation and output. Simulations for the estimated actual strategy and alternative regimes suggest that the vulnerability of the Russian economy to external shocks can substantially be lowered by adopting some form of inflation targeting. Strategies to target the nominal exchange rate or the ruble price of oil prove to be inferior.

Geldpolitik und Nachhaltigkeit

AbstractECB President Christine Lagarde and others have suggested that climate change creates risks for price stability and for the viability of counterparties to central bank interventions and therefore monetary policy should contribute to fighting climate change. However, pursuit of this new objective may occassionally conflict with price stability, in which case the legal mandate as well as the underlying rationale for this mandate and for ECB independence call for prioritising price stability. However, monetary policy will have a sustainability problem of its own if the viability of the monetary system is threatened by financial and fiscal instability.

The interdependence of foreign exchange vulnerability in emerging markets

PurposeThe foreign exchange market plays a crucial role in defining the overall health of an economy. In these times of globalization and (in some ways) deglobalization, these markets are highly vulnerable to external shocks. In this line of research, this study investigates exchange-market vulnerability among the BRICS economies by considering the co-movements among variables and contagion among markets.Design/methodology/approachThis study uses DCC-IGARCH and Wavelet approaches to examine interdependence and contagion among the foreign exchange markets of the BRICS countries. The prior approach gives exposure to correlations over time, while the latter approach is suitable to provide insight regarding correlations over different frequency and time domains.FindingsThese results show evidence of meaningful co-movements in the vulnerability of the BRICS economies' foreign exchange markets during periods of market instability. The authors observe that interdependence significantly increased after 2008 and is prominent in the short run, particularly up to the scale of 1.5 years. In addition, there is evidence of persistent integration across the short and medium run. Furthermore, the findings indicate recurrent patterns of co-movements and the presence of contagion.Originality/valueGiven the high degree of economic integration among the BRICS economies, there is relatively little literature on how each member country's foreign exchange vulnerability can affect others. This research fills this gap, by applying appropriate econometric techniques and using a newly created measure of exchange market vulnerability that is unit consistent—such that it combines observed change in exchange rates with the change that is prevented through central bank intervention in a common unit, rather than by combining percentages with dollar-denominated values. This research provides important implications for investors and policymakers.

A Dilemma between Liquidity Regulation and Monetary Policy: Some History and Theory

AbstractHistory suggests a conflict between current Basel III liquidity ratios and monetary policy, which we call the liquidity regulation dilemma. Although forgotten, liquidity ratios, named “securities‐reserve requirements,” were widely used historically, but for monetary policy (not regulatory) reasons, as central bankers recognized the contractionary effects of these ratios. We build a model rationalizing historical policies: a tighter ratio reduces the quantity of assets that banks can pledge as collateral, thus increasing interest rates. Tighter liquidity regulation paradoxically increases the need for central bank's interventions. Liquidity ratios were also used to keep yields on government bonds low when monetary policy tightened.

Central Bank Intervention in the Inflation Targeting

Abstract This paper analyses the impact of central bank interventions in the inflation targeting regime. The results of empirical studies in this paper show if there is a shock of the exchange rate, which would lead to depreciation of the exchange rate, a central bank may decide to mush instability on the foreign exchange market with foreign exchange interventions, thereby preventing the sudden exchange rate depreciation, which would then require a smaller reaction by the interest rate. Namely, through foreign exchange interventions, the central bank greatly absorbs the depreciation shock and, consequently, inflation is lower. As a result of lower price growth, the need for a monetary policy response to an interest rate is also lower. Based on this example, we can see that central bank intervention in some cases can be very useful in order to correct disturbances in the foreign exchange market. Therefore, some central banks accumulate foreign exchange reserves at a very high level so as to have enough space for foreign exchange intervention, without the risk of falling foreign exchange reserves below the optimum level.

Saved by the Bell? Equity Market Responses to Surprise COVID-19 Lockdowns and Central Bank Interventions

Saved by the Bell? Equity Market Responses to Surprise COVID-19 Lockdowns and Central Bank Interventions

Leaning against the Bubble: Central Bank Intervention in Walrasian Asset Markets

The paper presents a two-period Walrasian financial market model composed of informed and uninformed rational investors, and noise traders. The rational investors maximize second period consumption utility from the payoffs of trading risk-free holdings to risky assets in the first period. The central bank reacts directly to asset price movements by selling or buying assets to stabilize the market price. It is found that the intervention makes the risky asset’s market price per share less sensitive to information shocks, which presses the market price towards its average price thus reducing price variance. The informed investors’ prediction coefficient remains unaffected, but that of the uninformed investors is magnified, which cancels out the negative effect on shock sensitivity thus keeping the expected value of the risky asset’s dividend constant. Finally, the introduction of the policy rule does not affect rational investors’ risk per share. A general conclusion is that the central bank’s policy can be regarded as an effective automatic stabilizer of financial markets.

‘Whatever it takes’ to change belief: evidence from Twitter

The sovereign debt literature suggests the possibility that a self-fulfilling default crisis might be avoided if markets believe the central bank will act as lender of last resort. This paper investigates the extent to which changes in belief about an intervention of the European Central Bank (ECB) explain the sudden reduction of government bond spreads for the distressed countries in summer 2012. The authors study Twitter data and extract belief using machine learning techniques. They find evidence of strong increases in the perceived likelihood of ECB intervention and show that those increases explain subsequent decreases in the bond spreads of the distressed countries.

Financialisation, regional economic development and the coronavirus crisis: a time for spatial monetary policy?

This paper argues that ‘spatial monetary policy’ may be needed to achieve more territorially balanced economic development. Central banks have been key in fostering financialised economies while also preventing their collapse in times of crisis—a role further strengthened by the coronavirus pandemic. Central banks have thus become the most powerful economic policy-making institutions, just when spatial disparities are likely to deepen. In the context of crisis-ridden financialised capitalism, regional development policies should consider the spatial implications of central bank interventions and recognise monetary policy as a key element of spatial policy. Simultaneously, monetary policy should embrace an explicit spatial agenda.

Sidedness in the interbank market

We study the motivations of traders in the interbank market around the 2007–2009 subprime crisis. We extend the market sidedness of Sarkar and Schwartz (2009) to a panel setting to study the dispersion of beliefs for banks domiciled in different European countries. We find that country-level sidedness reveals information from the interbank market: sidedness leads sovereign credit default swap (CDS) spreads and reacts to central bank interventions introduced during the crisis. Our results map the linkages between the interbank market and sovereigns, as well as provide insight on the channels that give rise to the sovereign-bank nexus.

Net Present Value, Duration, and CAPM in Light of Investment Theory: A Comment on Kruk

In her paper “Corporate Risk Evaluation in the Context of Austrian Business Cycle Theory” recently published in this journal, Joanna Kruk aims to investigate how artificially low interest rates resulting from central bank intervention distort individual investment appraisals and ultimately result in both entrepreneurial misjudgment and resource-wasting malinvestment, fueling the business cycle. She identifies entrepreneurs’ net present value calculations, supposedly unadjusted for risk, as a major issue and suggests adjusting those calculations for risk via both the duration method and the Capital Asset Pricing Model to mitigate the distorting effects. Her argumentation is, however, trapped in neoclassical reasoning and is adversely affected by several misconceptions of the net present value criterion. This comment seeks to reveal those fallacies and explain how to address uncertainty when using net present value calculations to make those calculations part of the solution rather than part of the problem of entrepreneurial misjudgment. The findings are derived from German investment theory rooted in the Austrian school of thought, meaning that they differ compared to those of neoclassical finance theory.

Modeling Sources of Asymmetry in the Volatility of the Moroccan Dirham Exchange Rate

The main objective of this paper is to study the sources of asymmetry in the volatility of the bilateral exchange rates of the Moroccan dirham (MAD), against the EUR and the USD using the asymmetric econometric models of the ARCH-GARCH family. An empirical analysis was conducted on daily central bank data from March 2003 to March 2021, with a sample size of 4575 observations. Central bank intervention in the foreign exchange (interbank) market was found to affect the asymmetry in the volatility of the bilateral EUR/MAD and USD/MAD exchange rates. Specifically, sales of foreign exchange reserves by the monetary authority cause a fall in the exchange rate, which means that the market response to shocks is asymmetric. Finally, the selection criterion (AIC) allowed us to conclude that the asymmetric model AR(1)-TGARCH(1,1) is adequate for modeling the volatility of the exchange rate of the Moroccan dirham.

The effects of FX-interventions on forecasters disagreement: A mixed data sampling view

We analyse the heterogeneity of exchange rate forecasts by a panel of professional forecasters. Adopting the view that forecasters’ economic behaviour is such that they constantly collect, process and analyse relevant information when producing forecasts, we apply a Mixed-Data Sampling (MIDAS) regression approach. This enables us to explore the roles played by key drivers for which available data are at different frequencies from forecast disagreement. Examining the Colombian peso/U.S. dollar exchange rate, we find that central bank intervention is most effective in reducing heterogeneity in the very short-run, and when conducted against a background of high exchange rate volatility.

One state, one interest? How a historic shock to the balance of power of the Bundesbank and the German government laid the path for fiscal austerity

Many economies in the Western world have been through a regime shift towards fiscal austerity since the 1970s. Existing scholarship ascribes trends in austerity to globalisation or the influence of a new economic paradigm. This paper develops a different approach by stressing the strategic intervention of central banks in governments’ fiscal decisions. It analyses archival documents from the German Federal Cabinet and the Bundesbank Council over more than two decades (1960–1981) and finds that the fiscal regime was shaped by changes in transnational institutions which the central bank used to strategically expand its institutional power within the larger macroeconomic framework. With the breakdown of the Bretton Woods system, the Bundesbank was able to greatly increase its power resources while the government’s powers diminished. The Bundesbank used its new powers to strategically ‘overreach’ into the fiscal sphere and ‘bargain’ with the government to achieve fiscal reforms. By shedding light on the interactions of global legal and economic developments and the micro-level strategies of state actors, the paper proposes a more complex view of the role of the state and brings state-actor strategies into our understanding of the grand shifts in economic policymaking.

Liquidity Restrictions, Runs, and Central Bank Interventions: Evidence from Money Market Funds

Liquidity restrictions on investors, like the redemption gates and liquidity fees introduced in the 2016 money market fund (MMF) reform, are meant to improve financial stability. However, we find evidence that such liquidity restrictions exacerbated the run on prime MMFs during the COVID-19 crisis. Our results indicate that gates and fees could generate strategic complementarities among investors in crisis times. Severe outflows from prime MMFs led the Federal Reserve to intervene with the Money Market Mutual Fund Liquidity Facility (MMLF). Using MMLF microdata, we show how the provision of “liquidity of last resort” stabilized prime funds.