Intervention may Increase Volatility

Central bank intervention could actually increase exchange rate volatility if intervention increases private sector uncertainty about central bank policies. Suppose the central bank surprises traders by intervening to increase the value of the dollar but announces neither the intervention's magnitude nor its motivation. In making their trades, foreign exchange traders have to guess the meaning of the intervention and attempt to infer the implications of the action for future policy.

Because their trades are based on incomplete information, traders will need to revise their currency positions once more information about intervention policy becomes available. These changes in currency positions imply changes in the exchange rate and hence greater exchange rate volatility. Market uncertainty about the likelihood of future central bank intervention could also lead to greater exchange rate volatility.

Because central banks do not announce their plans for intervention, foreign exchange traders must base their currency positions on their best guesses of whether and when central banks will intervene. These currency positions and hence exchange rates will change over time as traders reassess the likelihood of central bank intervention. Uncertainty over central bank intervention policy can contribute to exchange rate volatility. Central bank intervention can also increase exchange rate volatility by increasing the likelihood of speculative bandwagons.

For instance, intervention might increase volatility if market participants think the central bank is unable or unwilling to prevent speculative forces from pushing the exchange rate in a particular direction. Suppose the dollar exchange rate falls from 120$ to 115$ and that speculators expect the dollar to fall further to 110$. As before, a speculator selling the dollar at 115$ might expect to realize a profit if the dollar falls to 110$.

The expected profit opportunity encourages other speculators to jump on the bandwagon, thereby actually pushing down the dollar. Since the traders are uncertain about the intervention policy. The uncertainty about intervention policy may encourage speculation and cause price changes and exchange rate volatility to be higher than in the absence of such intervention.