Sterilised vs Unsterilised Foreign Exchange Intervention

When a central bank intervenes in the foreign-exchange market to move its currency’s value, it can either offset the effect on the domestic money supply (sterilised intervention) or allow the money supply to change (unsterilised intervention). This choice fundamentally shapes how the intervention affects inflation, interest rates, and the broader economy.

What Is Foreign Exchange Intervention?

Central banks intervene in currency markets to influence the exchange rate. They might buy their own currency (pushing it up) if it has depreciated too sharply, or sell it (pushing it down) if it has appreciated and hurt exporters. The transaction itself is straightforward: the central bank writes a check in a foreign currency or domestic currency and settles the trade in the foreign-exchange market.

But intervention has a side effect: it changes the monetary base—the stock of cash and reserves in the banking system. When a central bank buys foreign currency, it typically pays by crediting the selling bank’s reserve account with new domestic currency. This increases the money supply. When it sells foreign currency, it drains domestic currency from reserves. This decreases the money supply.

The decision to sterilise or not determines whether the central bank allows that side effect to persist or reverses it.

Sterilised Intervention: Isolating the Exchange-Rate Effect

In sterilised intervention, the central bank acts in two steps: it intervenes in the foreign-exchange market, then immediately offsets the impact on the money supply with an opposite operation in the domestic bond market.

Example: The Bank of Japan wants to weaken the yen (boost exports). It buys $1 billion worth of US Treasury bonds, paying in newly created yen. This increases the yen money supply. To sterilise the effect, the Bank of Japan simultaneously issues ¥1 billion in domestic bonds, draining that new yen from the banking system. The net result is the same money supply but a different portfolio: banks hold fewer yen reserves and more yen-denominated government bonds.

The exchange rate may move—if market participants believe the Bank of Japan is signaling a weak-yen policy, the yen depreciates even though money is not looser. But the monetary side of the economy is untouched. Interest rates, inflation expectations, and credit conditions remain stable.

Sterilised intervention is the theoretically “clean” way to target the exchange rate without inflaming inflation or loose money. Central banks use it when they want to nudge the currency without triggering broader economic stimulus or stagflation risk.

Unsterilised Intervention: Letting Money Flow

In unsterilised intervention, the central bank intervenes and does not offset the money-supply effect. When it buys foreign currency and credits bank reserves with new domestic currency, that money stays in the system.

Example: The Bank of Mexico buys $500 million in US Treasury bonds to support the peso (buy pesos, sell dollars). The money supply increases by ₱500 million equivalent. Banks now hold more pesos than before. They lend more readily, interest rates fall, and the economy has more liquidity. This additional purchasing power can boost growth—but it also risks inflation if the money chases too few goods.

Unsterilised intervention is more powerful and more inflationary. It works because it changes the money supply. If the goal is to expand the economy and weaken the currency (to stimulate exports), unsterilised intervention does both at once.

The Fundamental Trade-off

The choice between the two hinges on what outcome the central bank prioritizes:

Sterilised: Good for exchange-rate targeting in the short run, especially if the central bank wants to avoid inflation or unintended monetary looseness. Bad because it is expensive—the central bank must pay the difference between the yield on foreign assets (often low US Treasury rates) and the yield on domestic bonds (often higher). If done repeatedly, sterilised intervention can drain the central bank’s profits and erode its balance sheet.

Unsterilised: Good for long-term currency weakness (because the expanding money supply will cause domestic inflation, which erodes competitiveness gradually, weakening the currency further). Good for economic stimulus. Bad because it surrenders control over the money supply and inflation, and it is economically powerful in ways the central bank may not intend. Once unleashed, the money is hard to call back.

Empirical Track Record

Research on intervention’s effectiveness is mixed. Sterilised intervention appears to have little lasting effect on exchange rates unless it is backed by a change in monetary policy expectations. Markets eventually see through it—the money supply hasn’t changed, so why should the currency stay weak? If the central bank is not genuinely committing to a looser policy path, sterilised intervention is a costly façade.

Unsterilised intervention works more reliably, but it forces the central bank to sacrifice its primary mandate (price stability) for the secondary goal (exchange-rate management). Most advanced-economy central banks have concluded that the trade-off is not worth it; they have abandoned sustained exchange-rate targeting in favor of allowing the market to set the rate.

Historical Examples

In the 1990s and 2000s, many emerging-market central banks used sterilised intervention to prop up their currencies during capital outflows. The Bank of Thailand, Bank of Korea, and others bought their own currencies and sold bonds to drain the extra yen or baht. The strategy worked for a time but was costly and eventually failed as speculators recognized the unsustainability. Many of these episodes ended in currency crises.

Conversely, when the US Federal Reserve expanded its balance sheet during and after 2008 (quantitative easing), it was performing unsterilised intervention—buying long-term bonds and letting the money supply expand. This was explicitly inflationary in intent: the goal was to lower real interest rates and stimulate the economy, not to move the exchange rate. The unsterilised nature of the policy made it powerful.

China’s central bank has historically used sterilised intervention to resist currency appreciation, buying US dollars and selling bonds domestically. This kept the yuan weak relative to the dollar and supported exporters, but it also required continuous issuance of sterilisation bonds—a growing liability.

When Central Banks Choose Each Approach

Sterilised intervention is preferred when:

• The central bank wants to tweak the exchange rate without altering monetary conditions.
• Inflation is already a concern, and loosening the money supply would be counterproductive.
• The intervention is expected to be temporary or small-scale.

Unsterilised intervention is preferred when:

• The central bank wants to ease monetary policy and weaken the currency simultaneously.
• The economy is in recession and needs stimulus.
• The currency is persistently overvalued and the central bank accepts that inflation will gradually resolve it.

Most modern central banks in developed countries rely on unsterilised intervention only as part of their primary monetary-policy toolkit (ie, interest-rate changes and balance-sheet expansion). They rarely use sterilised intervention except in moments of acute currency turmoil or crisis.

See also