Unsterilized and Sterilized Foreign Exchange Interventions

The central banks of most major economies allow their foreign exchange rates to float, since this allows capital to find its most efficient uses worldwide and because it allows the central banks to set domestic interest rates that comports with their monetary policy. Hence, usually the markets determine what the foreign exchange rates will be.

Some countries, such as China, where exports are an important part of the economy, routinely intervene in the FX markets to keep their currency from appreciating. However, these countries must give up their ability to control their own interest rates, since higher interest rates draws capital seeking a higher return from around the world, which would cause the domestic currency to appreciate. Some countries do attempt to maintain some control over their domestic policy while also maintaining the foreign exchange rate of their currency within certain bounds by instituting capital controls. China, for instance, restricts the trading of its currency.

Central banks that want to maintain control of their domestic monetary policy rarely intervene in the foreign exchange markets for an extended duration, because market forces will quickly return the exchange rate to the currency's supply-demand equilibrium after the intervention ends. Interventions, therefore, are conducted to blunt large currency moves caused by major events or market uncertainties that would normally have only a temporary effect on the exchange rate. For instance, during the recent Japanese earthquake and tsunami, the Japanese yen was increasing in strength because it was feared that insurance companies would have to sell foreign assets to convert to yen to pay for damages and such a fear caused many traders involved in the yen carry trade to unwind their positions, strengthening the yen even more. Because a strong yen hurts Japanese exports, the central banks of the G-7 economies decided to intervene by selling yen to lower its exchange rate.

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In the United States, the U.S. Treasury has primary responsibility for international fiscal policy, but usually consults with the Federal Reserve. Any foreign intervention carried out by the United States is conducted by the New York Fed, which is the fiscal agent for the United States.

The purchase or sale of currencies is almost always conducted in the spot market, since spot transactions have an immediate effect on the foreign exchange rate and market forces would blunt any effect of forward transactions.

When central banks intervene to weaken the currency, they sell their reserves of the currency on the open market; when they want to strengthen the currency, they buy the currency by exchanging their domestic currency for the foreign currency. For instance, if the Federal Reserve wanted to strengthen the euro, it would contact the foreign exchange department of a commercial bank and buy German bonds, which are denominated in euros. The purchase would be paid for by increasing the reserves of the commercial bank in its account that is maintained at the Federal Reserve. This is almost exactly equivalent to an open market operation where the Federal Reserve would buy Treasuries from its primary dealers by increasing the reserves of the dealers by the amount of the purchase. The only difference from the purchase of the German bond and the purchase of a Treasury is that the increase in the Federal Reserve's assets consists of German bonds rather than Treasuries. Both operations increase the money supply. If the Federal Reserve does nothing else to offset the transaction, then it has engaged in an unsterilized foreign exchange intervention.

The currency used to intervene in the exchange market is drawn either from the holdings of the Federal Reserve or from the Exchange Stabilization Fund, which consists mostly of euros and yen.

The New York Fed will sometimes act as fiscal agent for other central banks and intervene in the exchange market on their behalf, using their deposits that are held by the Federal Reserve. This allows the central bank to conduct foreign exchange interventions that are outside of its normal business hours or to trade with banks that often conduct business with the Fed. Because the Fed does not use its own reserves for the intervention, it does not need to sterilize the intervention.

Sterilized Intervention

A sterilized foreign exchange intervention occurs when the central bank buys a foreign currency and offsets the increase in the domestic currency by selling domestic government securities, which decreases the money supply by the amount of the securities.

A sterilized foreign exchange involves at least 2 transactions — the purchase or sale of foreign currency reserves, followed by an open market operation of the same size to offset the impact of the first transaction on the monetary base.

When the Federal Reserve buys foreign bonds, it has the exact same effect on the money supply and interest rates as buying United States Treasuries: both purchases increase the amount of reserves, thereby increasing the money supply by the amount of the purchase, which reduces the interest rate because of the increased supply of money. Therefore, to offset the foreign purchase, the Fed sells Treasuries.

So if the Federal Reserve buys €1,000,000 worth of German bonds, which are denominated in euros, and if the euro is worth 1.5 United States dollars, then, without any other action, the money supply would increase by the 1.5 million-dollar purchase. But if the Fed sells $1.5 million worth of Treasuries, then that money is withdrawn from the economy — in effect, sterilizing the purchase of the German bonds.