Sterilized Intervention

What Is Sterilized Intervention?

Sterilized intervention is the purchase or sale of foreign currency by a central bank to influence the exchange value of the domestic currency, without changing the monetary base.

Figuring out Sterilized Interventions

One of the primary devices utilized by the Federal Reserve to influence monetary policy is its target for the federal funds rate, which is set by the Federal Open Market Committee principally to accomplish domestic objectives. Since the Federal Reserve could never permit its intervention activities to affect its monetary policy operations, it generally utilizes sterilized intervention. Central banks of major countries — like the Bank of Japan and the European Central Bank — which likewise utilize an overnight interest rate as a short-term operating target, moreover clean their currency interventions.

The U.S. Treasury Department is responsible for determining the country's exchange rate, and for that purpose, it keeps up with the Exchange Stabilization Fund (ESF), which is a portfolio of foreign currency and dollar-designated assets. The Federal Reserve likewise has a foreign currency portfolio for a similar purpose. Exchange rate intervention is carried out jointly by the Treasury and Federal Reserve.

Sterilized interventions include two separate transactions:

1. The sale or purchase of foreign currency assets
2. An open market operation including the purchase or sale of government securities (in a similar size as the main transaction).

The open market operation effectively offsets or cleans the impact of the intervention on the monetary base. Assuming that the sale or purchase of the foreign currency isn't joined by an open market operation, it would amount to an unsterilized intervention. Empirical evidence proposes that sterilized intervention is generally unequipped for changing exchange rates.

Illustration of Sterilized Intervention

Think about a simple illustration of sterilized intervention. Accept that the Federal Reserve is worried about the weakness of the dollar against the euro. It, thusly, sells euro-designated bonds in the amount of EUR 10 billion, and it gets $14 billion in proceeds from the bond sale. Since the withdrawal of $14 billion from the banking system to the Federal Reserve would influence the federal funds rate, the Federal Reserve will quickly conduct an open market operation and buy $14 billion of U.S. Treasuries.

This infuses the $14 billion back into the monetary system, sanitizing the sale of the euro-named bonds. The Federal Reserve in effect likewise rearranges its bond portfolio by trading euro-designated bonds for U.S. Treasuries.

Sterilized Intervention versus Carry Trade

Towards the finish of the last century, a common reason for some sterilized interventions was a high money supply which pushed nearby interest rates below the international average, which made the conditions for a carry trade — market participants would borrow at home and loan abroad at a higher interest rate.

Carry trade applies descending pressure on the currency being borrowed. As sterilized interventions don't reduce an all around high money supply, domestic interest rates will in any case be low. Participants keep borrowing at home and lending abroad and the central bank needs to mediate once more to forestall any future depreciation of its domestic currency. This can't continue always, on the grounds that the central bank will ultimately run out of currency reserves.

Highlights

• Sterilized intervention is the purchase or sale of foreign currency by a central bank to influence the exchange value of the domestic currency, without changing the monetary base.
• Sterilized interventions include the sale or purchase of foreign currency assets and an open market operation including the purchase or sale of government securities (in a similar size as the main transaction).
• Empirical evidence recommends that sterilized intervention is generally unequipped for adjusting exchange rates.