Central Bank Monkey Business: Should Central Banks Determine Exchange Rates?


There's an emerging debate in global economic circles over central banks acting as arbiters in setting exchange rates. Currently valued at $5.3 billion, the worldwide foreign exchange market (which is comprised of over 200 currencies) is 12 times larger than the futures market and 27 larger than the stock market, according to industry data—so the stakes are certainly high in the global currency exchange market.

Businesses and the Proper Assessment of Global Exchange Rates

Getting a good grip on foreign currency exchange rates is a significant priority for global businesses. Recognizing the value of a given currency against a separate foreign currency can provide clarity for investors to properly value assets priced in foreign dollars.

For instance, a U.S. equity investor who knows the U.S. dollar to euro exchange rate can make a better call on potential return outcomes when buying stocks in Spain, France, or other European countries.

If the dollar is falling against the euro, an overseas investor can expect price appreciation when buying European stocks. Conversely, if the dollar is on the rise against the euro, that investors could see the value of his or her equity purchase slide downward. (The U.S. dollar is a key benchmark in most foreign currency exchanges, as it comprises 62.7% of all global foreign exchange reserves at the end of 2017 , according to the International Monetary Fund.)

Tilting the Playing Field?

Thus, the importance of setting foreign exchange rates accurately is imperative. Though market rates, reflective of actual market transactions, are largely considered the most accurate indication of foreign exchange conversion, global central banks in the last few years have been playing a much larger role when determining these rates.

     Central banks may act on sentiment
     of the ruling government and set
     rates that favor one nation's economy
     at the expense of another.

Central banks can set exchange rates directly or indirectly. Consider China, where the government directly sets fixed exchange rates, or the U.S., which uses its central bank, the Federal Reserve, to indirectly set exchange rates through periodic interest rate hikes or cuts its key fed funds rate (the interest rate at which banks, credit unions, and other depository lenders lend their reserve balances to other depository institutions on an overnight basis).

One burgeoning fear among investors is that central banks may act on sentiment of the ruling government and set exchange rates that favor one nation's economy at the expense of another. Consider President Trump's “America First" policy, which some economists say steers the Federal Reserve to make interest rate decisions that favor U.S. economic interests over global economic interests. Ideally, central banks and national governments would work symmetrically in setting exchange rates, taking into consideration key economic factors like global economic interests and national government priorities.

If central banks and governments leave any imbalance in the exchange rate equation, they run the risk of picking global “winners and losers" when making key exchange rate decisions. That could upset the equilibrium economists, investors, consumers, and businesses require when making key financial decisions.

Should Central Banks Intervene in Global Currency Markets?

Some economists lean to the oppositional side when deciding whether central banks should set exchange rates. Thomas Straubhaar, an economics professor at the University of Hamburg writing in Intereconomics Review of European Economic Policy, states that—theoretically and within a flexible system—central banks should leave the process of determining appropriate exchange rates to the currency markets.

“Supply and demand and the reactions of currency traders to changes in the macroeconomic setting result in the free floating of exchange rates," says Straubhaar. “In practice, however, central banks have frequently intervened to 'manage' the exchange rates according to their goals and priorities."

     "Central banks have frequently
     intervened to 'manage' the exchange
     rates according to their goals and

Straubhaar cites a recent example of the Swiss National Bank's push for a weaker Swiss franc, which ultimately failed, negatively impacting the Swiss economy and ultimately placing the country at high risk of being the world's largest currency speculator. Here, Straubhaar makes his case for central banks to surrender to currency markets as the best arbiter of exchange rates: “The lessons other countries could learn from the Swiss experience are, firstly, that a strong currency can be a stimulus rather than a liability for the economy, and secondly, that central banks might be well advised to abstain from market interventions to weaken the national currency."

The Takeaway in Central Banks and the Setting of Exchange Rates

  1. No doubt, the practice of central banks intervening in global exchange markets will continue to spark discussions among economists, investors, and businesses. The takeaway after most discussions seems to be straightforward: when central banks set exchange rates according to their goals and priorities, more losers than winners ultimately accumulate across the global economic landscape.

The goal for businesses and investors who depend on accurate currency exchange rates is to understand the country-by-country policy on exchange rates, whether they're market-driven or established by a central bank, and act accordingly.

Since businesses have no control over exchange rate movements engineered by market-driven movements or any moves by central banks, the goal is to stay on top of of exchange rate movements on a regular basis - signing up for an automatic feed of central bank exchange rates is considered best practices. Even better to work with a trusted financial partner who knows what jurisdictions mandate the use of central bank rates over market rates. It'll become more and more important for businesses to get ahead of the curve as central bank activism increases in the years to come.

Read more about central bank rates versus market rates here.