Unsterilized Foreign Exchange Intervention

Overview

Unsterilized foreign exchange intervention occurs when a country’s monetary authorities intervene in the currency market without offsetting operations to neutralize the effect on the domestic money supply. By buying or selling foreign assets and allowing the corresponding change in the monetary base to stand, the central bank combines exchange-rate goals with direct monetary consequences.

How it works

• When a central bank purchases foreign currency or foreign assets, it pays with domestic currency. If the operation is unsterilized, this increases the domestic monetary base (more domestic currency in circulation).
• Conversely, when a central bank sells foreign assets and buys domestic currency, the domestic monetary base contracts if the action is unsterilized.
• Because no offsetting open-market operations occur, unsterilized interventions change monetary conditions (liquidity, interest rates) as well as the exchange rate.

Why central banks use unsterilized intervention

• To influence the exchange rate directly while accepting the monetary consequences rather than insulating the economy.
• To counter excessive currency appreciation or depreciation that could harm export competitiveness or trigger disruptive inflation.
• To signal policy intent and shift market expectations about future currency levels.

Comparison with sterilized intervention

• Sterilized intervention: Central bank offsets the FX transaction with domestic open-market operations (e.g., sells or buys domestic bonds) so the domestic money supply remains largely unchanged. The goal is to influence the exchange rate while insulating monetary conditions.
• Unsterilized intervention: No offsetting transactions are made, so the action directly alters the domestic monetary base and can influence interest rates and inflation as well as the exchange rate.

Example

• If a central bank buys foreign government bonds using domestic currency and does not sell domestic assets to offset that purchase, the domestic monetary base increases. The higher supply of domestic currency tends to weaken that currency, while the central bank’s foreign asset holdings rise.
• If instead the bank sells foreign reserves to buy back domestic currency and does not offset the purchase, the domestic money supply shrinks and the domestic currency tends to strengthen.

Effects and limitations

• Monetary impact: Unsterilized intervention affects liquidity and interest rates, so it can amplify or counteract other monetary policy objectives.
• Inflation risk: Increasing the monetary base can be inflationary if not managed alongside other policy tools.
• Credibility and expectations: Effectiveness depends on market perceptions of the central bank’s commitment and policy horizon.
• Reserve constraints: Persistent intervention can deplete or build up foreign reserves, limiting future options.
• Not always decisive: Large or well-anchored markets may require repeated or large interventions to shift exchange rates.

Key takeaways

• Unsterilized interventions change both exchange rates and the domestic money supply because no offsetting operations are performed.
• They can be a deliberate mix of exchange-rate management and monetary policy but carry risks (inflation, loss of monetary control, reserve depletion).
• Effectiveness depends on the central bank’s credibility, the size of intervention relative to the market, and broader economic context.