Interdependencies between monetary policy and foreign exchange interventions under inflation targeting: The case of Brazil and the Czech Republic

The bulk of recent literature on foreign-exchange interventions has overlooked the potential interdependencies that may exist between interventions and the conduct of monetary policy. This is the case even under inflation targeting, especially in emerging-market economies, because central banks often explicitly reserve the right to calm disorderly markets and to accumulate foreign reserves, and when the exchange rate is perceived as out of step with fundamentals. This paper uses a friction model to estimate intervention reaction functions for Brazil and the Czech Republic since adoption of inflation targeting in these countries in 1998 and 1999, respectively. The main findings are that: i) in both countries interventions occur predominantly to reduce exchange-rate volatility, while in Brazil the central bank also reacts to exchange-rate deviations from medium-term trends; ii) there are strong, asymmetric threshold effects in the functions, and interventions are more likely and of higher magnitudes when they aim at depreciating than appreciating the domestic currency; and iii) interventions seem to take place independently of monetary policy in Brazil, but not in the Czech Republic, where both policies appear to be interrelated.