[Research Contribution] Foreign Exchange Intervention in the Inflation Targeting Monetary Policy Framework in Emerging Economies

5 March, 2025

Keywords: Foreign exchange intervention, Monetary policy, Interest rate, Emerging economies, Asymmetric effects

The role of foreign exchange intervention in monetary policy management is an ongoing controversial issue, especially in emerging economies following the inflation targeting framework in monetary policy management. The research at University of Economics Ho Chi Minh City (UEH) is to help us to better understand this issue!

In the 1990s, many countries faced severe economic and financial crises. This prompted them to reform their financial systems and monetary policy frameworks to prevent hyperinflation and restore the economy. Since the introduction of inflation targeting in New Zealand in 1990, a growing number of emerging economies have adopted this framework, changing their exchange rate regimes from “fixed” to “floating” and changing the nominal anchor from “exchange rate” to “inflation”. In theory, monetary authorities in countries adopting an inflation targeting framework must commit to an explicit inflation target and a floating exchange rate regime, known as strict inflation targeting. Such an explicit commitment reduces inflation expectations (Mishkin and Schmidt-Hebbel, 2007) to enhance the credibility of the central bank and make this framework more sustainable than other frameworks. However, the actual implementation of monetary policy is a different story in emerging economies, where monetary authorities often manage exchange rates to some extent by changing interest rates or intervening in the foreign exchange market. This framework is known as flexible inflation targeting. Therefore, a debate has emerged in recent years as to whether the consistency of inflation targeting monetary policy with its primary objective – inflation – is actually satisfactory.

Although there are many studies on foreign exchange intervention policy (Adler et al., 2021; Banerjee et al., 2018; Ding and Wang, 2022; Faltermeier et al., 2022; Hansen and Morales, 2019; Kaminsky and Lewis, 1996; Krizek and Brcak, 2021; Mohanty and Berger, 2013; Rakhmad and Handoyo, 2020; Rossini et al., 2013), the link between foreign exchange intervention and monetary policy seems to have been overlooked in existing research. As is well known, although foreign exchange intervention is rather popular and frequently used in emerging countries (Chang, 2008; Domaç and Mendoza, 2004; Hansen and Morales, 2019; Humala and Rodríguez, 2010; Krizek and Brcak, 2021; Sideris, 2008; Villamizar‐Villegas, 2016), studies on the relationship between them and monetary policy are scarce in these economies. This article by the UEH author aims to fill these research gaps by examining the relationship between foreign exchange intervention and monetary policy in emerging economies where the inflation targeting framework is applied.

The article provides extensive empirical evidence and discusses important aspects of the interaction between these two policies in emerging economies with inflation targeting monetary policies, and answers critical research questions as follows:

First, how do interest rates respond to foreign exchange interventions?

Second, do interest rates respond asymmetrically to buying and selling interventions?

Third, how do structural shocks affect the relationship between foreign exchange interventions and monetary policy?

This research applies the ARDL model to analyze the dynamics of the foreign exchange intervention-monetary policy nexus in 12 emerging economies pursuing inflation targeting. The empirical results provide evidence of the important role of foreign exchange interventions in the implementation of monetary policy in these countries. In particular, changes in foreign exchange reserves lead to changes in interest rates in most emerging economies. The negative impact is evident in many countries (Brazil, Colombia, Mexico, Romania, Turkey, and South Africa); nevertheless, the positive impact is evident in a few economies (Hungary). Furthermore, it should be noted that the intervention effects are influenced by structural shocks like the 2007-2009 global financial crisis and the Covid-19 pandemic. Finally, the impact of FX interventions on interest rates is asymmetric, with a bias towards short FX interventions. Specifically, short FX interventions have a significant impact on interest rates in most emerging economies while the impact of long FX interventions is significant only in Thailand.

These findings also have some implications for market participants and policymakers. First, market participants should consider the information embedded in the intervention policy when analyzing the stance of monetary policy and the behavior of monetary authorities in emerging market inflation-targeting economies. This is because foreign exchange intervention has a significant impact on interest rate setting in most emerging market economies while the effects may be asymmetric and inconsistent across countries.

For policymakers, the widespread use of foreign exchange intervention and its significant impact on interest rates may provide misleading information regarding monetary policy priorities in emerging market economies adopting an inflation-targeting framework. This may lead to public confusion or frustration and undermine the credibility of the central bank. However, these problems can be mitigated by improving the transparency of monetary policy and foreign exchange intervention. It is recommended to maintain goal coherence between monetary policy and foreign exchange interventions. Interventions should not occur when they undermine the ability to meet inflation target commitments. In any case, interest rates should be adjusted first. Meanwhile, interventions should be used sparingly and they should be used as a complementary tool of monetary policy.

Although foreign exchange interventions play an important role in the context of emerging economies, their understanding is being limited. Future studies should further investigate whether foreign exchange interventions are related to inflation or exchange rate developments. An affirmative answer to the first statement would demonstrate that foreign exchange intervention is a tool used to address inflationary pressures, implying the existence of a multi-tool framework in the implementation of monetary policy in emerging economies pursuing an inflation targeting framework. In fact, the conventional inflation targeting framework does not deny the fact that exchange rates have an impact on monetary policy. According to Svensson (1999), monetary authorities should respond to any variable that contains information regarding the evolution of inflation. On the other hand, an affirmative answer to the second statement would indicate the active use of intervention policy to address changes in exchange rates. This would imply the existence of a dual target or multi-tool framework although the inflation targeting framework is applied in emerging economies.

The full-text article on Foreign Exchange Intervention in the Inflation Targeting Monetary Policy Framework in Emerging Economies can be accessed HERE.

Author: Dr. Bui Thanh Trung – University of Economics Ho Chi Minh City.

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