Using daily data from the Czech Republic in 1/1/1998-31/12/2002, we find that foreign exchange intervention activity is determined by the degree of exchange rate misalignment and lagged intervention. Additionally, inflation targeting regime is a binding constraint of intervention activity.

Roman Horvath

English

Research Papers in Economics

Modelling Central Bank Intervention Activity under Inflation
Targeting 
Roman Horvath
Czech National Bank and IES, Charles University
Abstract
Using daily data from the Czech Republic in 1/1/1998-31/12/2002, we find that foreign
exchange intervention activity is determined by the degree of exchange rate misalignment
and lagged intervention. Additionally, inflation targeting regime is a binding constraint of
intervention activity.
I thank Robert F. Engle for helpful discussions. I also thank Ian Babetskii, Jarko Fidrmuc and Luboš Komárek for the help in
obtaining the data used in this paper. All remaining errors are entirely my own. The views expressed here do not necessarily
represent those of the Czech National Bank.
Citation: Horvath, Roman, (2007) "Modelling Central Bank Intervention Activity under Inflation Targeting." Economics
Bulletin, Vol. 6, No. 29 pp. 1-8
Submitted: June 4, 2007.  Accepted: August 2, 2007.
URL: http://economicsbulletin.vanderbilt.edu/2007/volume6/EB-07F40018A.pdf1
1. Introduction
Several  studies  have  recently  analyzed  the  determinants of  central  bank’s  foreign 
exchange (FX) intervention
1 activity under flexible exchange rates (Almekinders and 
Eijffinger,  1994,  1996;  Baillie  and  Osterberg,  1997;  Neely,  2002;  Kim  and  Sheen, 
2002; Frenkel, Pierdzioch and Stadtmann, 2004; and Ito and Yabu, 2006). Typically, 
they  find  that  central  bank  (CB  hereafter)  intervenes  in  the  FX  market,  when  the
exchange rate is largely misaligned and/or excessively volatile.
2
The  literature  on  the  determinants  of  CB  intervention  rarely  explicitly  links  FX 
intervention  behavior  to  CB’s  monetary  policy  regime.  This  is  striking,  as  CBs
typically do not formulate their FX intervention policy in an ad hoc manner (reacting 
merely  to  information  in  exchange  rate),  but  rather consider  the  overall  economic 
outlook and the consequences of FX intervention for price stability.
3
In this paper, we focus on assessing how monetary policy regime (inflation targeting in 
our case) affects CB’s FX intervention activity. We build on anecdotal evidence by 
Geršl  and  Holub  (2006),  who  propose  the  criteria  for  assessing  FX  interventions 
consistency with the inflation targeting regime. The criterion we analyze in this paper
is simply that the CB should tighten the monetary conditions when inflation and output
forecast is heading  above its targeted value and vice versa (Geršl and Holub, 2006, 
label it as target consistent). If CB interventions are in line with the aforementioned 
criterion, we label it as consistent with inflation targeting (IT consistency hereafter).
As a result, this paper aims to bridge the gap in evidence on the linkages between FX 
intervention activity and inflation targeting regime using the daily data from the Czech 
Republic. First, we construct a simple indicator of “IT consistency” based on deviation 
of inflation and output from its target levels. Second, we estimate the determinants of
FX intervention activity employing the measures of exchange rate misalignment and 
volatility and IT consistency.
The paper is structured as follows. Data and empirical methodology are described in 
section 2. Results are presented in section 3. Conclusion follows in section 4.
2. Data and Methodology
The sample period runs from 1/1/1998 to 31/12/2002. We use daily data on actual FX
interventions and CZK/EUR exchange rate (prior to 1999 CZK/EUR is retrieved from 
CZK/DEM and irrevocable fixing rate of DEM/EUR).
4 We also employ monthly data 
on net inflation, as the inflation target of the Czech National Bank (CNB) has been 
                                                
1 We define interventions as sales or purchases of foreign currency by the central bank intended to influence the 
level or volatility of exchange rate.
2 See Sarno and Taylor (2001) for comprehensive survey of FX intervention literature.
3 Note that the most closely related literature to ours is on signaling effect of FX interventions. More specifically, 
Lewis (1995) finds that monetary variables such as interest rates help to forecast FX interventions and Kaminsky 
and Lewis (1996) analyze whether FX interventions signal future monetary policy actions. Our approach differs 
here from this stream of literature, as we narrow our interest to linking FX interventions activity to inflation 
targeting regime rather than monetary variables in general. 
4 This is motivated by the fact that FX interventions have been conducted vis-à-vis DEM until 1999.2
defined in terms of net inflation during the sample period.
5 Real GDP growth data are 
available on a quarterly basis (HP filter is used to estimate potential growth).
As mentioned above, we define the inflation targeting consistency variable ( t IT ) using 
the  difference  between  net  inflation  and  inflation  target  and  output  gap  estimate  as 
follows: 
                                             
* *
t t t t t y y IT                                                     (1)
where  t   is the yearly net inflation,
*
t   is the net inflation target,  t y  is actual GDP 
growth and 
*
t y  is an estimate of potential growth. We estimate   and    by principal 
components. This is simply motivated for the ease of exposition in the empirical part, 
as we then obtain single parameter showing whether the considerations about inflation 
targeting regime have served as important constraint for the FX intervention activity.
Alternatively, we also allow    and    to be estimated within the equation on the FX 
intervention  determinants  in  (3).
6 Additionally,  the  rationale  for  using  the  current 
values  of  inflation  and  output  gap  instead  of  its  forecasts  is  uncertainty  in  future 
developments in an economy undergoing massive structural changes during the sample 
period.
7
Generally,  we  link  FX  intervention  activity  to  its  lagged  value  (to  address  the
persistence of interventions), exchange rate developments and the IT consistency. In 
line with Ito and Yabu (2006), we first estimate the following probit model:
                  
MA
t t t t t t t s s s s s s INT P 1 1 3 21 1 2 2 1 1 0 1                                    (2)
t INT  denotes a binary variable taking value of one, when the CNB intervenes in day t; 
zero otherwise. t s  is the CZK/EUR exchange rate.
MA
t s  represents the moving average 
of  t s   using  365  days  window.  As  a  result,  1  ,  2    and  3  capture  the  short-term, 
medium-term and long-term movements of exchange rate, respectively.
8 The sign of
2  and  3  is expected to be negative, i.e. intervention activity is inversely related to 
                                                
5 CNB started targeting inflation in 1998. Except inflation developments, the bank reaction function 
includes also output gap. Given the openness of Czech economy, the CNB may also react to exchange 
rate  developments  in  case  they  seriously  jeopardize  the  inflation  prospects.  See  Geršl  and  Holub
(2006) on inflation targeting design in the Czech Republic.
6 These results are available upon request.
7 As macroeconomic variables are not available at the daily frequency, we assume least squares learning about 
the state of economy and thus interpolate ITt linearly to daily values. The rationale for the exercise is as follows. 
CBs typically produce forecasts on a quarterly basis and in the meantime collect new information and analyze it 
to what extent it shifts the outlook from the last forecast. It is vital to note that different interpolation procedures 
such as quadratic match procedure had infinitesimal effect on the results presented in the section 4.
8 Alternatively, we estimate short-term exchange rate volatility using a GARCH model of and take the estimates 
of medium-term exchange rate misalignment from Babetskii and Egert (2005) and Crespo-Cuaresma, Fidrmuc 
and MacDonald (2005). The results, using these alternative specifications, are similar to those presented in this 
paper and are also available upon request.3
the deviation of the exchange rate from its last month value or its moving average. The 
sign of  1   is unconstrained (see Sarno and Taylor, 2001), though we expect it to be 
positive, as the CNB sells the domestic currency, when the currency appreciates. It is 
noteworthy that the CNB conducted intervention almost only against the appreciation 
of domestic currency (CNB intervened in 89 days selling the CZK, only 4 days buying 
the CZK out of 1242 sample days)
9.
To  investigate  if  the  inflation  targeting  regime  served  as  important  constraint  of 
CNB’s FX intervention activity, we next estimate regression of the form:
              t
MA
t t t t t t t IT s s s s s s INT P 4 1 1 3 21 1 2 2 1 1 0 1                                 (3)
Given  our  definition  of t IT ,  we  expect  0 4   ;  i.e.  CNB  is  less  likely  to  intervene 
against the appreciation of currency, when the difference between the inflation and its 
target rises (analogously for output gap).
To address the sensitivity of results, we proceed in two steps. First, following Frenkel 
et al. (2004), we define  t INT as the number of consecutive intervention days. Using 
this alternative indicator, we estimate the identical set of FX intervention determinants
as in (2) and (3) by the negative binomial model. Second, we estimate the following 
equation by OLS:
      t t t
MA
t t t t t t t INT IT s s s s s s INT                         1 5 4 1 1 2 21 1 2 2 1 1 0           (4)
t INT   is  defined  as  in  the  equation  (1)  and  alternatively  using  the  actual  daily  FX 
intervention volume. 
4. Results
The monthly intervention volumes and exchange rate developments are presented in 
Figure 1. As apparent from Figure, there has been three major intervention episodes
associated primarily with the sharp CZK/EUR appreciation (the first half of 1998, end 
of 1999, and mid 2002). 
                                                
9 Given the fact that the intervention has been primarily oriented against appreciation of CZK, we do not opt for 
the ordered probit model.4
Figure 1 – CZK/EUR exchange rate and intervention volumes
28
30
32
34
36
38
40
1
/
9
8
5
9
1
/
9
9
5
9
1
/
0
0
5
9
1
/
0
1
5
9
1
/
0
2
5
9
Time
C
Z
K
/
E
U
R
-200
0
200
400
600
800
1000
1200
m
i
l
.
 
E
U
R
Source: Czech National Bank
Note: The left scale measures the CZK/EUR exchange rate; the right scale measures the monthly FX 
intervention volume in the millions of euro. 
Table 1 – Estimation Results
Neg. Binomial Probit OLS - indicator OLS - volume
2 1    t t s s 1.00 1.08* 0.66 0.67 0.07 0.08 0.63 0.68
(0.62) (0.59) (0.44) (0.43) (0.06) (0.06) (0.59) (0.59)
21 1    t t s s -1.26*** -0.85*** -0.58*** -0.41*** -0.05*** -0.24** -0.20*** -0.18***
(0.21) (0.18) (0.10) (0.10) (0.01) (0.10) (0.06) (0.06)
MA
t t s s 1 1    -0.17*** -0.30*** -0.08* -0.13*** -0.01 -0.01 -0.01 -0.01
(0.07) (0.09) (0.04) (0.04) (0.01) (0.01) (0.02) (0.02)
t IT -0.61*** -0.36*** -0.05*** -0.03*** -0.07* -0.07*
(0.14) (0.06) (0.01) (0.01) (0.04) (0.04)
1  t INT 0.52*** 0.08**
(0.05) (0.03)
No. of obs. 1262 1262 1262 1262 1262 1262 1262 1262
R-sqr. 0.08 0.11 0.07 0.14 0.07 0.33 0.02 0.03
Note: McFadden’s R-squared for the negative binomial and probit model. Intervention volume is in the 
billions  of  CZK. Robust  standard  errors  in  parenthesis.  ***,  **,  and  *  -  denotes  significance  at  1 
percent, 5 percent, and 10 percent, respectively.
Table 1 reports our results on the determinants of FX intervention activity. Typically, 
the  CNB  does  not  react  to  day-to-day  exchange  rate  volatility  and  rather  has  been 
concerned with the medium to long-term exchange rate developments. This is in line 
with  the  official  bank  statements  expressing  that  intervention  have  been  conducted 
only when the CZK/EUR appreciated excessively  (see Geršl and Holub, 2006). The 
results  also  suggest  that  inflation  targeting  regime  is  important  constraint  for  FX 5
intervention activity. More specifically, the more inflation and output is above their 
targeted  values,  the  less  likely  the  CNB  will  intervene  against  domestic  currency 
appreciation.
10 Therefore, our results comply with Geršl and Holub (2006), who argue 
that most of CNB’s FX interventions appear to be target consistent. In addition, there 
is  also  evidence  for  clustering  of  FX  intervention  activity  (though  intervention 
volumes are much less ‘persistent’). 
5. Conclusions
In  this  paper,  we  study  the  determinants  of  FX  intervention  activity  of  the  Czech 
National Bank. The novelty of our approach is the examination of the role of inflation 
targeting  regime  on  this  activity.  Subject  to  various  sensitivity  tests,  we  find  that
inflation  targeting  regime  is  important  constraint for  the  central  bank interventions. 
Besides, central bank reacts to the medium-term exchange rate misalignment. We also 
find that intervention activity occurs in clusters.
                                                
10 The results using a monthly lag of IT to address the potential endogeneity are similar and available on request.6
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Why Do Central Banks Intervene?”

Modelling Central Bank Intervention Activity under Inflation Targeting

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Modelling Central Bank Intervention Activity under Inflation Targeting

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