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Japanese Intervention was Not Sterilized – What Does that Mean?
The Bank of Japan said explicitly last night that their intervention will NOT be sterilized. This is VERY good because it gives their intervention efforts a greater chance of succeeding.
Intervention by central banks is one of the most important short-term and long-term fundamental drivers in the currency market. For short-term traders, intervention can lead to sharp intraday movements on the scale of 150 to 250 pips in a matter of minutes. For longer-term traders, intervention can signal a significant change in trend because it suggests that the central bank is shifting or solidifying its stance and sending a message to the market that it is putting its backing behind a certain directional move in its currency.
There are basically two types of intervention, sterilized and unsterilized. Sterilized intervention requires offsetting intervention with the buying or selling of government bonds, while unsterilized intervention involves no changes to the monetary base to offset intervention.
The intervention by the Japanese government in 2003-2004 was sterilized which is part of the reason why it was unsuccessful. The government sold Yen with money financed by the issuance of bills. When intervention is not sterilized, the money supply is increased because the funds used to sell Yen may be raised by printing money.
Many argue that unsterilized intervention has a more lasting effect on the currency than sterilized intervention and thankfully the latest intervention is not sterilized.
Quoting the Cleveland Federal Reserve who published a working paper titled Sterilized Intervention, Nonsterilized Intervention, and Monetary Policy in 2001:
Sterilized intervention is generally ineffective. Countries that conduct monetary policy using an overnight interbank rate as an intermediate target automatically sterilize their interventions. Unsterilized interventions can influence nominal exchange rates, but they conflict with price stability unless the underlying shocks prompting them are domestic in origin and monetary in nature. Unsterilized interventions, however, are unnecessary since standard open-market
operations can achieve the same result.
How is Intervention Sterilized?
According to the Cleveland Federal Reserve, this is how the sterilization of intervention is done:
Sterilization occurs automatically by virtue of the Federal Reserve’s operating procedure. The FRBNY’s Open Market Desk manages total reserves in the U.S. banking system in such a way as to achieve the federal funds target that the Federal Open Market Committee (FOMC) establishes in its monetary-policy deliberations. The FOMC actions are almost always taken with domestic objectives—inflation, business-cycle developments, financial fragility—in mind. Given its estimate of depository institutions’ demand for total reserves, the Desk manages the supply of reserves through open-market operations to keep the actual federal funds rate at the target. In the process, the Desk must take account of a number of factors that appear on the Federal Reserve’s balance sheet and that can affect the amount of reserves in the banking system at any time. Among these items are changes in the Treasury’s cash balances and changes in the Federal Reserve’s portfolio of foreign exchange. The Federal Reserve staff will attempt to estimate these on a day-to-day basis, but whether anticipated or not, the Fed will respond to them quickly in defense of the federal funds target. Consequently, intervention is never permitted to change reserves in a manner that is inconsistent with the day-to-day maintenance of the federal fund rate target. All central banks, including the Bank of Japan and the European Central Bank, that use an overnight, reserve-market interest rate as a short-term operating target necessarily sterilize their
interventions in this way.
The Federal Reserve has on occasion adjusted its monetary policy stance with an exchange market objective in mind, and it has sometimes intervened in the foreign exchange market while altering its federal funds target. Whether one refers to such interventions as nonsterilized or as a combination of a sterilized intervention in conjunction with a monetary policy change is inconsequential. In either case, the intervention is completely unnecessary since domestic open-market operations alone can achieve the same objective.