Forex Trading Exchange Rate: Fixed or Floating?

To most traders the exchange rate norm has always been freely floating. When trading forex, you have to get used to volatile exchange rates and have learned to plan accordingly. Businesses seek to hedge their transactional or translational risk according to a combination of their business needs and market conditions. Politicians have a mixed record with floating exchange rates, frequently viewing exchange rate strength as a sign of national economic virility—and exchange rate weakness consequently as a test of their own administration.

Yet, it is not that long ago that such a test would have been unthinkable. Freely floating exchange rates are themselves a comparatively new phenomenon. Indeed, the period since 1973 and the break-up of the Bretton Woods exchange rate system has been the first sustained time in history in which the world’s major currencies have not been pegged to some form or other of commodity.

Such a world of freely floating exchange rates, massive private capital flows financing current account deficits and markets dictating government monetary and fiscal policies was completely inconceivable in 1944 when Bretton Woods was created.

To recap, under this, member countries pledged to maintain their currencies within narrow bands against the US dollar, while the dollar itself was pegged to gold (at USD35 per ounce). Some degree of flexibility was allowed, but there was never any suggestion—or conception—that governments were not in charge.

For 27 years, the Bretton Woods system held in place, helping to provide a foundation for economic growth in the 1950s and 1960s.

Then, as the value of the US dollar peg to gold came under ever increasing pressure, the

US eventually scrapped its gold peg, trying in the process to create a slightly more flexible

exchange rate system under the Smithsonian Agreement.

In 1973, the effort to defend this too was exhausted and collapsed under the weight of its own contradictions. Thus, since 1973, we have had for the first time an international monetary system which has for the most part been characterized by freely floating exchange rates among the major industrial countries, free of official intervention or commodity-related pegs, with “the market” taking an increasingly important role, both relative to before 1973 and also to official government policy.

Granted, since then, there have been several attempts, such as the Exchange Rate Mechanism

(ERM), to shackle exchange rates within narrow bands. For the most part, such attempts to reassert government control over the market have given way to some degree of accommodation

between the two sides, with freely floating exchange rates allowed but official intervention

seen as appropriate at times of extreme volatility or where prices have “overshot” economic

fundamentals.

This accommodation has resulted in specific victories of a sort for both sides. The ERM itself, having barely survived the 1992 crisis, was forced under extraordinary pressure in  1993 to widen its bands to ±15% from ±2.25%.

However, since then, member countries have relinquished their national currencies in favor of the Euro, thus eliminating the question of fixed or floating at the national level. The Euro itself is still however a freely floating currency, as its volatile movements have born testimony.

Still, for the most part, the question of having a fixed or floating exchange rate regime has increasingly become a redundancy for the world’s industrial countries, particularly as barriers

to trade and capital have been broken down.

The US dollar, Euro, yen, sterling and others all float against each other, for the most part without official interference. While there are still occasional bouts of intervention by the central bank, these are nowadays a relative rarity.

What has become far more common is that central banks will attempt to guide the market through “verbal intervention”. The extent of the accommodation arrived at by the market and

the official community is such that this for the most part works well enough, though to be  sure there are times when it is not enough and substantial foreign exchange intervention in the market has to be undertaken.

For forex traders in the industrial countries however, such as corporations or institutional investors, the question of the type of exchange rate regime is largely (though perhaps not completely) no longer relevant. National currencies may bind together to become regional currencies, but the bottom line is that they are still freely floating and not artificially pegged.