All central bank(er)s have a soft spot for exchange rates. In most developed economies they leave this market alone. However, from time to time a certain level of the exchange rate is perceived by the authorities as dangerous for the economy. A level deemed too weak will threaten inflation and one deemed too strong will threaten growth.
I do not favor market interventions especially in the foreign exchange market. Central banks do have the power to control the market for some time but while they do “funny” things happen to the behavior of the market participants as the true market signal is distorted by the intervention. Basically the economy functions taking into account information that has been filtered: maybe the measured inflation is lower than it should have been or maybe the economic growth is perceived as higher than in reality and they spend more. In either case saving and investment decisions will be based on false or distorted information.
If the central banks will be able to commit that they will keep a certain exchange rate forever than my argument above is false as in the end the economy will adjust to this equilibrium. Unfortunately this is not true. Central banks, with very few exceptions, will only be able to control an exchange rate for a certain period of time. And with the end of the interventions cycle comes the adjustment towards where the level of the economy would have been in the absence of the central bank. Some times this process is very fast and painful and sometimes is smooth and it takes longer. The problem is that we do not know before hand on how the economy will respond without the central bank interventions.
Here is a concrete case: the EURCHF exchange rate.
The SNB decided that a level below 1.2 for the EURCHF will be harmful to the economy. To keep the rate there it had to increase the monetary base from 77 billion CHF to 252 billion CHF. This massive increase in the MB moved the exchange rate from 1.12 EURCHF to 1.23 EURCHF. But today, 4 months later, the EURCHF rate is at 1.2055 and the monetary base has decreased to 225 billion CHF. The question in from of us is: how long will the SNB keep pumping money to hold the EURCHF rate above 1.2? It does not look that they will hold this line much longer in my view. I think the SNB will in the near future announce either that it denounces the 1.2 level or that it will move that level a bit lower to 1.15 or 1.