The Practice of Central Bank Intervention: Looking under the Hood
Neely, Christopher J., Federal Reserve Bank of St. Louis Review
There has been a long and voluminous literature about official intervention in foreign exchange markets. Official intervention is generally defined as those foreign exchange transactions of monetary authorities that are designed to influence exchange rates, but can more broadly refer to other policies for that purpose. Many papers have explored the determinants and efficacy of intervention (Edison, 1993; Sarno and Taylor, 2000) but very little attention has been paid to the more pedestrian subject of the mechanics of foreign exchange intervention like choice of markets, types of counterparties, timing of intervention during the day, purpose of secrecy, etc. This article focuses on the latter topics by reviewing the motivation for, methods, and mechanics of intervention. Although there apparently has been a decline in the frequency of intervention by the major central banks, reports of a coordinated G-7 intervention to support the euro on September 22, 2000, remind us that intervention remains an active policy instrument in some circumstances.
The second section of the article reviews foreign exchange intervention and describes several methods by which it can be conducted. The third section presents evidence from 22 responses to a survey on intervention practices sent to monetary authorities.
TYPES OF INTERVENTION
Intervention and the Monetary Base
Studies of foreign exchange intervention generally distinguish between intervention that does or does not change the monetary base. The former type is called unsterilized intervention while the latter is referred to as sterilized intervention. When a monetary authority buys (sells) foreign exchange, its own monetary base increases (decreases) by the amount of the purchase (sale). By itself, this type of transaction would influence exchange rates in the same way as domestic open market purchases (sales) of domestic securities; however, many central banks routinely sterilize foreign exchange operations--that is, they reverse the effect of the foreign exchange operation on the domestic monetary base by buying and selling domestic bonds (Edison, 1993). The crucial distinction between sterilized and unsterilized intervention is that the former constitutes a potentially useful independent policy tool while the latter is simply another way of conducting monetary policy.
For example, on June 17, 1998, the Federal Reserve Bank of New York bought $833 million worth of yen (JPY) at the direction of the U.S. Treasury and the Federal Open Market Committee. In the absence of offsetting transactions, this transaction would have increased the U.S. monetary base by $833 million, which would tend to temporarily lower interest rates and ultimately raise U.S. prices, depressing the value of the dollar. [l] As is customary with U.S. intervention, however, the Federal Reserve Bank of New York also sold an appropriate amount of U.S. Treasury securities to absorb the liquidity and maintain desired conditions in the interbank loan market. Similarly, to prevent any change in Japanese money market conditions, the Bank of Japan would also conduct appropriate transactions to offset the rise in demand for Japanese securities caused by the $833 million Federal Reserve purchase. The net effect of these transactions would be to increase the relative supply of U.S. government securities versus Japanese securities held by the public but to leave the U.S. and Japanese money supplies unchanged.
Fully sterilized intervention does not directly affect prices or interest rates and so does not influence the exchange rate through these variables as ordinary monetary policy does. Rather, sterilized intervention might affect the foreign exchange market through two routes: the portfolio balance channel and the signaling channel. The portfolio balance channel theory holds that sterilized purchases of yen raise the dollar price of yen because investors must be compensated with a higher expected return to hold the relatively more numerous U. …