What is a ‘Floating Exchange Rate’
A floating exchange rate is a regime where the currency price is set by the forex market based on supply and demand compared with other currencies. This is in contrast to a fixed exchange rate, in which the government entirely or predominantly determines the rate. The currencies of most of the world’s major economies were allowed to float freely following the collapse of the Bretton Woods system in 1971.
BREAKING DOWN ‘Floating Exchange Rate’
Floating exchange rate systems mean that while long-term adjustments reflect relative economic strength and interest rate differentials between countries, short-term moves can reflect speculation, rumors and disasters, either natural or man-made. Extreme short-term moves can result in intervention by central banks, even in a floating rate environment.
The Bretton Woods Conference took place in July 1944; it takes its name from the resort in New Hampshire where it took place. A total of 44 countries met, with attendees limited to the Allies in World War II, which had not yet ended. The Conference established the International Monetary Fund and the World Bank, and it set out guidelines for a fixed exchange rate system. The system established a gold price of $35 per ounce, and participating countries pegged their currency to the dollar. Adjustments of plus or minus 1% were permitted. The dollar became the reserve currency through which central banks carried out intervention to adjust or stabilize rates.
The first large crack in the system appeared in 1967, with a run on gold and an attack on the British pound that led to a 14.3% devaluation. President Richard Nixon took the United States off the gold standard in 1971. By late 1973, the system had collapsed, and participating currencies were allowed to float freely.
Central Bank Intervention
In floating exchange rate systems, central banks buy or sell their local currencies to adjust the exchange rate; this can be aimed at stabilizing a volatile market or achieving a major change in the rate. Groups of central banks, such as those of the G-7 nations (Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States), often work together in coordinated interventions to increase the impact.
An intervention is often short-term and does not always succeed. A prominent example of a failed intervention took place in 1992, when financier George Soros spearheaded an attack on the British pound. The currency had entered the European Exchange Rate Mechanism (ERM) in October 1990; the ERM was designed to limit currency volatility as a lead-in to the euro, which was still in the planning stages. Soros believed that the pound had entered at an excessively high rate, and he mounted a concerted attack on the currency. The Bank of England was forced to devalue the currency and withdraw from the ERM. The failed intervention cost the U.K. Treasury a reported £3.3 billion.
Central banks can also intervene indirectly in the currency markets by raising or lowering interest rates to impact the flow of investors’ funds into the country.