Discussion Papers In Economics
And BusinessCentral Bank Independence and the Signaling Effect of Intervention:
A Preliminary Exploration

Shinji Takagi and Hiroki Okada

Discussion Paper 13-04

Graduate School of Economics andOsaka School of International Public Policy (OSIPP)
Osaka University, Toyonaka, Osaka 560-0043, JAPANCentral Bank Independence and the Signaling Effect of Intervention:
A Preliminary Exploration

Shinji Takagi and Hiroki Okada

Discussion Paper 13-04

March 2013

Graduate School of Economics andOsaka School of International Public Policy (OSIPP)
Osaka University, Toyonaka, Osaka 560-0043, JAPANMarch 2013

Central Bank Independence and the Signaling Effect of Intervention:
A Preliminary Exploration
Shinji Takagi† and Hiroki Okada††
Graduate School of Economics
Osaka University

Abstract:
This note explores the signaling effect of foreign exchange market intervention incountries, such as Japan, the United Kingdom and the United States, where separate
agencies are responsible for intervention and monetary policy. An important part of thesignaling effect operates when an entity conducting intervention makes a credible
commitment to a change in future monetary policy, suggesting that its effectivenesshinges upon whether the central bank is independent of government oversight. We test
this conjecture by comparing the consistency of intervention and future monetary policy
in Japan before and after April 1998, when central bank independence was established by
the new Bank of Japan Law. As expected, the signaling effect of intervention weakened
after the central bank became independent.
JEL classification: E42, F31, F33
Keywords: foreign exchange market intervention; Japanese intervention; central bankindependence; signaling effect of intervention
Running title: Central Bank Independence and the Signaling Effect of Intervention†

Shinji Takagi* (takagi@econ.osaka-u.ac.jp; takagishinji@hotmail.com), Professor of
Economics and ††Hiroki Okada (okadahiroki0621@gmail.com), graduate student:
Graduate School of Economics, Osaka University, 1-7 Machikaneyama, Toyonaka,
Osaka 560-0043, Japan; Tel: 81-6-6850-5225; Fax: 81-6-6850-5274*Corresponding author

I. INTRODUCTION
This note explores the signaling effect of foreign exchange market intervention,
an important part of which operates when an entity conducting intervention makes acredible commitment to a change in future monetary policy. If separate agencies are
responsible for intervention and monetary policy, as in Japan, Switzerland, the United
Kingdom or the United States, it is unclear if the government can credibly commit thecentral bank to change its future monetary policy. Thus, the validity of the monetary
policy channel of signaling must hinge upon whether the central bank is independent ofgovernment oversight. We test this conjecture by comparing the consistency ofintervention and future monetary policy in Japan before and after April 1998, whencentral bank independence was enshrined in the new Bank of Japan Law.
The rest of this note proceeds as follows. Section II reviews the conceptual issues
discussed in the literature concerning the signaling effect of foreign exchange market
intervention. Section III tests the impact of central bank independence on the signaling
effect of intervention in Japan, by postulating a simple probit model of the consistency of
foreign exchange market intervention and future monetary policy during 1980-2004.
Finally, section IV presents concluding remarks.
II. THE SIGNALING EFFECT IN THEORY AND PRACTICE
The signaling effect is considered to be the principal channel through whichintervention affects exchange rates. Under the normal operating procedure ofcontemporary central banks, any impact of intervention on the monetary base is sterilized
in order to maintain the policy interest rate (or the monetary base) at a target level. With
the direct monetary effect inoperative, intervention can affect exchange rates only1

through the portfolio balance or the signaling effect, but empirical work finds only weaksupport for the portfolio channel (Edison 1993; Sarno and Taylor 2001; Vitale 2007).
Studies of the signaling effect of US intervention in the late 1980s are mixed.
While Lewis (1995) identifies Granger causality from intervention to future monetary
policy, Kaminsky and Lewis (1996) and Klein and Rosengren (1991) report conflicting
or negative findings (see also Fatum and Hutchison 1999 for the period 1989-93). For
Swiss National Bank intervention, Payne and Vitale (2003), finding that only government
trades, but not customer trades conducted by the central bank, affected the dollar
exchange rate during 1986-95, conclude that the signaling effect is the only consistent
explanation.
For Japanese intervention, a large empirical literature has emerged since 2001
when official daily intervention data began to be disclosed (retroactive to April 1991).
Although studies utilizing different methodologies and samples have come to mixed
conclusions about its effectiveness, most of them suggest that intervention was effective,at least during some part of the period (Table 1). Given the likely substitutability between
dollar and yen assets, these studies appeal to the signaling effect to explain the impact ofintervention.
In Japan, the Ministry of Finance (MOF) intervenes in the foreign exchange
market by using a special account of the National Budget, with the Bank of Japan (BOJ)
acting as its agent. When purchasing (selling) dollars, the MOF issues (redeems)
financing bills (FBs), which are short-term government notes. Once issued, FBs arerolled over continuously as long as the underlying foreign assets are maintained as
official reserves. Sale of the underlying foreign assets reduces the outstanding balance of2

FBs to the extent that they are redeemed. Because FBs are sold to (or purchased from) the
public at market rates, this arrangement ensures that intervention is sterilized. 1
The signaling effect of intervention could conceivably involve several channels(e.g., the perception that the monetary authorities have superior information about theequilibrium exchange rate), we focus here on the monetary policy channel. We conjecture
that, in a system where the government conducts foreign exchange intervention, themonetary policy channel of signaling presupposes government oversight over the central
bank. In support of such a view, Watanabe (1994) shows that a fall (rise) in the discountrate and an increase (decrease) in the growth rate of money were consistently preceded bypurchases (sales) of foreign exchange during a period before 1 April 1998, when the new
Bank of Japan Law came into force.
To be sure, even if the central bank were independent, it could still collaborate
with the government. In Japan, an informal system of coordination may have existed
during the period of quantitative easing (2001-06) when the policy objectives of thegovernment and the central bank coincided (both wanted a weaker yen and an easiermonetary policy), even though the central bank was formally independent. Likewise, in
the United States, the Treasury and the Federal Reserve usually provide roughly equalamounts of funds when intervention takes place (FRB 2005). But collaboration cannot bea permanent feature of such a system, as separate agencies are bound to develop different
objectives from time to time. Kaminsky and Lewis (1996) observe, for example, that a
conflict with the US Treasury in the early 1990s led the Federal Reserve to quit
intervening on its own account. It is thus worth exploring whether the establishment of

1

When FBs are issued for intervention purposes, they are initially purchased by the BOJ in their entirety.
The BOJ will then unwind the position over time through weekly auctions.

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central bank independence in 1998 changed the information content of intervention about
future monetary policy in Japan.
III. TESTING THE IMPACT OF CENTRAL BANK INDEPENDENCE ON INTERVENTION
SIGNALING
In this section, we test the conjecture that the establishment of central bankindependence in April 1998 weakened the consistency of intervention and futuremonetary policy in Japan, thereby diminishing the signaling effect of intervention.
In particular, we estimate the following probit model:
x = α0 + α1 IND + α2 SEL + α3 QE + u(1)

where x is a binary dependent variable that takes the value of 1 when the direction ofintervention is consistent with the change in monetary policy over a 12-month horizon
and zero otherwise; IND is a dummy variable for central bank independence (IND=1
after April 1998 and zero otherwise); SEL is a dummy variable for yen-sellinginterventions; QE is a dummy variable for quantitative easing (QE=1 after March 2001
and zero otherwise); α0 is a constant, αi (i=1,3) is a coefficient to be estimated, and u is arandom error term. The QE dummy is intended to capture the possible presence of
informal collaboration between the government and the central bank.
The consistency measure, x, is defined in relation to the operating target used by
the Bank of Japan, namely: (i) the official discount rate through September 1994; (ii) the
unsecured overnight call rate from October 1994 through February 2001; and (iii) underquantitative easing, the current account balances (or deposits held by commercial banks
at the central bank), from March 2001 through the end of the sample period.

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We have identified as an intervention month any month during which intervention
took place. For the January 1980-March 1991 period, prior to the release of official data,
we estimated monthly interventions from the corresponding changes in the end-of-monthbalance of foreign exchange reserves, adjusted for the estimated interest earnings
obtained from multiplying the average balance by the US Treasury bill rate. We removed
from the sample any estimated intervention smaller than 100 billion yen, lest we falsely
ascribe a small change in the balance of foreign exchange reserves to intervention. 2
Equation (1) was estimated for January 1980-March 2004, using (i) allintervention months and (ii) only those months during which the amount exceeded 400
billion yen (Table 2). In both specifications, the coefficient of central bank independenceis negative and significant at the 5 percent level, suggesting that independence weakened
the consistency of intervention and monetary policy over the coming year. The
coefficient of quantitative easing is positive and significant at the 1 percent level,
suggesting that the MOF and the BOJ may have had similar objectives during March
2001-March 2004, irrespective of central bank independence. These results mean that,once adjusted for the impact of quantitative easing, the establishment of central bankindependence in April 1998 diminished the signaling effect of intervention.
IV. CONCLUSION
This note has made a preliminary exploration of the signaling effect of foreignexchange market intervention in Japan, where separate agencies are responsible forintervention and monetary policy. Testing the conjecture that the monetary policy
channel of signaling in such an environment hinges upon government oversight over the2Monthly data on intervention were obtained from the Ministry of Finance (www.mof.go.jp). Except for
the US Treasury bill rate (obtained from the International Monetary Fund, International Financial
Statistics), all other data come from the Bank of Japan (www.boj.co.jp).

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central bank, we have found that the consistency of intervention and future monetary
policy in Japan indeed weakened after April 1998, when the new Bank of Japan Lawestablished central bank independence.
It should be stressed, however, that the results are only tentative. Most of the postindependence sample (April 1998-March 2004) coincides with the period of quantitativeeasing (March 2001-March 2004), so that the estimated impact of central bankindependence during a “normal” period was based mainly on a rather small number ofobservations (35 months, from April 1998 to February 2001). Nor does the lack ofsignaling under central bank independence entirely refute the validity of the signaling
effect defined more broadly, which could conceivably involve multiple channels. Even so,
we can safely conclude that the signaling effect of intervention lost an important channelof influence in Japan when the central bank became independent.
REFERENCES
Chaboud, Alain P. and Owen F. Humpage, 2005, “An Assessment of the Impact ofJapanese Foreign Exchange Intervention: 1991-2004,” International FinanceDiscussion Paper No. 824, Board of Governors of the Federal Reserve System.
Edison, Hali J., 1993, “The Effectiveness of Central-Bank Intervention: A Survey of the
Literature after 1982,” Special Papers in International Economics, No. 18,
International Finance Section, Princeton University.
Fatum, Rasmus and Michael Hutchison, 1999, “Is Intervention a Signal of Future
Monetary Policy? Evidence from the Federal Funds Futures Market,” Journal of
Money, Credit and Banking, Vol. 31, 54-69.

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Fatum, Rasmus and Michael Hutchison, 2006, “Effectiveness of Official Daily Foreign
Exchange Market Intervention Operations in Japan,” Journal of International
Money and Finance, 199-219.
Fatum, Rasmus and Michael M. Hutchison, 2010, “Evaluating Foreign Exchange Market
Intervention: Self-Selection, Counterfactuals and Average Treatment
Effects,”Journal of International Money and Finance, Vol. 29, 570-584
Galati, Gabriele, William Melick, and Marian Micu, 2005, “Foreign Exchange Market
Intervention and Expectations: The Yen/Dollar Exchange Rate,” Journal ofInternational Money and Finance, Vol. 24, 982-1011.
Humpage, Owen F., 1991, “Central-Bank Intervention: Recent Literature, Continuing
Controversy,” Federal Reserve Bank of Cleveland Economic Review, 12-26.
Ito, Takatoshi, 2007, “Myths and Reality of Foreign Exchange Interventions: An
Application to Japan,” International Journal of Finance and Economics, Vol. 12,
133-154.
Kaminsky, Graciela L. and Karen K. Lewis, 1996, “Does Foreign Exchange Intervention
Signal Future Monetary Policy,” Journal of Monetary Economics, Vol. 37, 285312.
Kim, Suk-Joong and Jeffrey Sheen, 2006, “Interventions in the Yen-Dollar Spot Market:
A Story of Price, Volatility and Volume,” Journal of Banking and Finance, Vol.
30, 3191-3214.
Klein, Michael and Eric S. Rosengren, 1991, “Foreign Exchange Intervention as a Signalof Monetary Policy,” New England Economic Review, 39-50.

7Lewis, Karen K., 1995, “Are Foreign Exchange Intervention and Monetary Policy
Related and Does It Really Matter?” Journal of Business, Vol. 68, 185-214.
Nagayasu, Jun, 2004, “The Effectiveness of Japanese Foreign Exchange Interventions
during 1991-2001,” Economics Letters, Vol. 84, 377-381.
Payne, Richard and Paolo Vitale, 2003, “A Transaction Level Study of the Effects ofCentral Bank Intervention on Exchange Rates,” Journal of International
Economics, Vol. 61, 331-352.
Sarno, Lucio and Mark P. Taylor, 2001, “Official Intervention in the Foreign Exchange
Market: Is It Effective and, If So, How Does It Work?” Journal of Economic
Literature 39, September 2001, 839-868.
US Federal Reserve Board (FRB), 2005, “The Federal Reserve System Purposes andFunctions,” Board of Governors of the Federal Reserve System.
Vitale, Paolo, 2007, “An Assessment of Some Open Issues in the Analysis of Foreign
Exchange Intervention,” International Journal of Finance and Economics 12,
March, 155-170.
Watanabe, Tsutomu, 1994, “The Signaling Effect of Foreign Exchange Intervention: The
Case of Japan,” Reuven Glick and Michael M. Hutchison (eds.), Exchange Rate
Policy and Interdependence: Perspectives from the Pacific Basin, Cambridge and
New York: Cambridge University Press, 258-286.

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Table 1: Selected Empirical Studies on the Effectiveness of Daily Japanese Intervention
Using MOF Data
Study
1. Nagayasu(2004)

Methodology
Time-series/
GARCH

2. Chaboud andHumpage(2005)

Forecast value (ifsuccess
frequency
exceeds random
occurrence)
Time-series

3. Galati,
Melick, andMicu (2005)
4. Fatum andHutchison(2006)
5. Kim andSheen (2006)

6. Ito (2007)

Sample period/effectiveness
April 1991-September 2001
Unilateral
CoordinatedNo
Yes, but short-lived
April 1991-June
June 1995January 20031995
December 2002 March 2004
LimitedLimited
No

September 1993-April 2000
No

Event study

April 1991-March 2001
Yes

Exponential
GARCH(simultaneous
estimation ofmean andvariance)
Time-series

May 1991-June 1995
No

June 1995-March 2004
Yes

April 1991-June
June 1995January 20031995
January 2003
March 2004
Yes, only if
Yes
Yes
coordinated with
the US
7. Fatum andPropensity score
January 1999JanuaryJanuary-March
Hutchisonmatching
December 2002
December 2003 2004(2010)
Yes
No
No
Notes: Yes=intervention had effect in an intended direction; No=intervention had no or perverse
effect.

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Table 2: Estimating the Effect of Central Bank Independence on the Consistency ofIntervention and Future Monetary Policy
All interventions
Large interventions of more than 400
billion yen only
Coefficient Std.
Prob.
Coefficient Std. error Prob.
error-0.6490.207 0.002 0.086
0.407
0.832
Constant (α0)
Central bank
-0.8920.432 0.039 -1.044
0.522
0.046
independence (α1)
1.2450.287 0.000 0.576
0.500
0.247
Yen sales (α2)
Quantitative
1.482
0.555 0.008 1.568
0.591
0.008
easing (α3)
Diagnostic statistics:
NOB
114
54
2
Pseudo R
0.205
0.144
LR statistic
32.21 (0.000)
9.69 (0.021)(probability)

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