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This paper studies the effectiveness of foreign exchange rate targeting by a central bank in a market microstructure framework. Unlike the existing literature, where the intervening central bank either makes its target exchange rate public or hides it completely, we present a model that emphasizes the value of selectively disclosing intervention relevant information to some but not all market participants. We show that if the market's uncertainty over the central bank's target is sufficiently high and if the central bank is targeting the exchange rate away from its fundamental value (attempting to move the exchange rate in the opposite direction of where the fundamental based trade takes it) selectively disclosing the exchange rate target improves the effectiveness of the intervention.

Recent work on the so-called ‘secrecy puzzle’ surrounding official interventions in foreign exchange markets has rekindled the debate over the appropriate degree of transparency for foreign exchange intervention policy. The puzzle itself stems from the fact that operationally, most sterilized interventions are conducted in secret. Central bank interventions are reported, if at all, with a considerable time lag, and they may involve several exchange brokers or commercial banks in order to conceal the true size and intention of the intervention (Lyons, 2001 and Neely, 2001). As Sarno and Taylor (2001) argue, this secrecy is difficult to explain, given that the most common channel through which sterilized interventions are thought to work–the signaling channel–is ultimately more effective if the policy is announced publicly beforehand and the intervention is widely observed. Dominguez and Frankel (1993), in particular, make a strong case for transparency in central bank policy in foreign exchange markets, concluding, “intervention can be effective, especially if it is publicly announced and concerted.”1 The literature has provided some answers to the secrecy puzzle. Eijffinger and Verhagen (1997) address the issue of why a central bank may want to retain some degree of ambiguity as to the size of its intervention and conclude that some secrecy is desirable for short-term targeting. In the specific context of keeping the exchange rate target secret, Bhattacharya and Weller (1997) and Vitale (1999) develop market microstructure models of sterilized interventions that exploit signaling channels.2 Both of these papers follow the widely held view that sterilized interventions have no impact on the exchange rate's underlying fundamental value. Intervention can affect the interim exchange rate by changing market expectations regarding the fundamental. Vitale assumes the central bank knows the fundamental perfectly, and this information, along with its target exchange rate, determines the size of the bank's trade. In a market microstructure model à la Kyle (1985), the trades are obscured, since they are ‘batched’ along with orders originating from other traders. Conditioning on the total order flow, the market maker tries to extract information on the exchange rate fundamental.3 By concealing its target, the central bank can more effectively ‘fool’ the market. The main conclusion of Vitale (1999) is stark and leaves no room for full transparency: Whenever the central bank publicly discloses its target, a sterilized intervention is completely ineffective and the central bank cannot target the exchange rate.4 By and large, the literature on secrecy of interventions has focused on models where the intervening central bank either makes its exchange rate target public or hides it completely. Central banks, however, while hiding their hand from most of the market participants, routinely communicate their intentions to other central banks prior to interventions. Additionally, Chiu (2003), in her survey of 10 central banks, notes that central banks may convey privy information to some players in the market in order to increase the impact of the intervention and propagate its effect. This paper presents a model of exchange rate intervention which emphasizes the advantage of selectively disclosing intervention information to some but not all market participants. Specifically, we explore the related issues of transparency and information sharing as they apply to sterilized central bank interventions in foreign exchange markets and ask the following question: can a central bank achieve a more effective intervention outcome in a regime where it selectively discloses its target to certain market participants, like another central bank, while not making its intentions completely public? If so, how and when does this selective disclosure regime work?5 Our model builds on a market microstructure framework similar to Vitale's. This setting is particularly relevant for our exercise because of its stark conclusion in favor of the secrecy side of the debate. Different than previous applications, however, we exploit a novel feature of the market microstructure framework: too much market uncertainty on the central bank's target may also render intervention as ineffective. This follows, since in this case the price impact of any intervention is low. We show that precisely when the market has too much uncertainty on the central bank's targeting agenda, the bank may improve the price impact and hence the effectiveness of its intervention by selectively disclosing its target to another central bank trading in the market.6 We are drawn to the possibility that selective disclosure may improve the central bank's targeting on two accounts. The first is based on an insightful observation by Lyons (2001), which makes a distinction between speculative and target oriented trades regarding the price impact:7 An important difference between private trades and central bank trades is that private traders typically want to minimize the price impact, whereas central banks want to maximize the price impact (page 236). The second building block of our analysis is the central feature of the Kyle (1985) type microstructure model mentioned above. From the perspective of the market, the uncertainty on the target of the central bank is similar to the noise in the total order flow stemming from liquidity traders. Both the liquidity trade and the target based trade are fundamentally irrelevant, since they do not convey any information on the fundamental. When this fundamentally irrelevant noise in the total order flow is high, the market maker's pricing response (hence the price impact) to the order flow is low. This implies that a central bank's ability to target the exchange rate may also be very poor, if the market is too uncertain about the target. Our analysis identifies an important property of the regime with selective disclosure compared to the regime of complete secrecy: the price impact of a given order flow is always higher in the selective disclosure regime. Whether a selective disclosure regime achieves better targeting depends crucially on whether or not the central bank's targeting intention is consistent with the direction of the fundamental based trade. In other words, whether the central bank is targeting toward or away from the fundamental value is important. Interestingly, when the bank is targeting away from the fundamental value, (i.e., attempting to move the exchange rate counter to the direction of the fundamental based trade), selectively disclosing targeting information to another central bank trading in the market achieves a better targeting outcome if there is enough uncertainty on the intervening central bank's target. This follows, since as well as improving the price impact, selective disclosure also mollifies some of the fundamental based trade driving the exchange rate in the opposite direction from the target. On the other hand, when the bank wants to push further the exchange rate in the same direction as the fundamental based trade is taking it–an intervention policy that we call targeting toward the fundamental–the bank is never better off from selectively disclosing the target and complete secrecy is better. This follows, since doing so simply reduces the trades which would move the exchange rate in the same direction the bank wishes to take it. The analysis provides a clear answer to the practical policy question not addressed in the literature: is the intervening central bank always better off from hiding its target from other market participants who are already informed about the fundamental and who are acting on self interest rather than cooperating with the central bank? This question is important, since in the case of communicating the targeting intentions to fellow central banks, there is no clear evidence of full cooperation with the intervening central bank even in episodes of concerted interventions. Often, the central banks only share information on their intervention agendas without an explicit agreement of cooperative play. This fact is clearly documented by Sarno and Taylor (2001): Coordinated official intervention in the foreign exchange market occurs when two or more central banks intervene simultaneously in the market in support of the same currency, according to an explicit agreement of cooperation. In practice, however, concerted official intervention in the foreign exchange market among the major industrialized nations has largely consisted of information sharing and discussions (page 846). Our analysis has implications for the policy question of whether the central bank should always keep its target secret from major players who trade for their own interests without cooperation. In that respect, we show that information sharing between central banks can be a good policy alternative to complete secrecy, even if this communication does not involve a subsequent cooperative play. Therefore, we emphasize a point that seems to be overlooked in the literature: communication is not necessarily synonymous with cooperation.8 The paper proceeds as follows. Section 2 presents the model. Section 3 solves for the trading equilibria under complete secrecy and selective disclosure and compares the two regimes in terms of the price impact and the trading intensities. Section 4 provides a detailed comparison of targeting effectiveness under the two regimes and contains our main result. Section 5 concludes.

To summarize, the main contributions of the paper are as follows: (i) Unlike the existing literature, we consider an intervention regime where the central bank is not restricted to disclose the target to all or keep it secret from all. The possibility of disclosing the target to some but not all market participants (selective disclosure) is clearly a practical policy alternative to be considered. (ii) In a framework where a publicly known target renders intervention as ineffective, we show that too much market uncertainty on the target also undermines effective intervention. If the market is highly uncertain about the central bank's target, the equilibrium price impact of a given order flow is low and this makes it more difficult for intervention to work. Therefore, we point out that too much secrecy may not be the best intervention strategy either. (iii) We characterize the circumstances under which selective disclosure is the preferred intervention regime in terms of better targeting.14 We explore the price impact channel (i.e., the equilibrium response of the market price to the total order flow) and show that price impact under selective disclosure is always higher relative to complete secrecy. Since selective disclosure mutes some of the fundamental based order flow, the bank can achieve better targeting with complete secrecy when it is trying to move the exchange rate in the same direction as the market fundamental trade flow (target toward the fundamental). On the other hand, if the central bank is targeting away from the fundamental value, selective disclosure achieves better targeting when the public uncertainty on its target is high enough. Our analysis also emphasizes that information sharing between the central banks can be a good policy alternative for intervention, even if this communication does not involve a subsequent concerted and cooperative play. We should preface that intervention during currency crises differ substantially from the type of interventions considered here and in Vitale (1999) and Bhattacharya and Weller (1997). Crises typically emerge when market participants believe that a country is unable to maintain a fixed exchange rate. In this context, the central bank's target (the fixed exchange rate) is known by all market participants — what is not known by the market is the bank's stock of foreign reserves. In defending the exchange rate, a central bank may forgo its usual sterilization procedures in order to send a more convincing statement to the market. These may include a variety of policy initiatives that play a fundamental role in determining the banks reserves — one of the last, of course, being a change in the exchange rate. By contrast, one may think of interventions in the Vitale model as part of a normal operating procedure of the bank; the bank has sufficient foreign reserves, and the exchange rate–though targeted–is not fixed by the bank. The intervention practices of the Bank of Japan for the last quarter century seem to best fit this description. One broader implication of our work centers on the policy alternatives available to a central bank when it wants to reduce some of the uncertainty surrounding its target.15 The bank can adjust the market's priors and reduce the variance of its target directly, by making public pronouncements about its target before trades commence. Alternatively, it can reduce the variance selectively (and in our case, to zero), for some but not all market participants. The bank will, presumably, need to reveal more information selectively to an informed trader than it would reveal publicly in order to achieve the same targeting effect. Both require that the information the bank relays is credible. Arguably, it should be easier for the bank to convey its true intentions to a portion of the market only, especially if such communications are limited to other central banks. Moreover, transmitting noisy messages publicly is a blunt, and potentially more costly, approach. For example, the central bank may run the risk that its message is confused by the general public with other aspects of its monetary policy, thereby affecting the market's priors on the fundamental itself. In the event that this occurs, it may be difficult if not impossible for the bank to retract its pronouncements, which will, no doubt, come at considerable cost to the bank's reputation. Missing here, as in much of the microstructure literature, is a clear connection between exchange rate interventions strategies and the broader concerns of monetary policy. This remains an important and potentially fruitful area for future research.