Sterilised Intervention and the Money Supply

A sterilised intervention is a foreign exchange operation in which a central bank buys or sells foreign currency to influence exchange rates, then immediately offsets the impact on the domestic money supply through open market operations. The result is a change in the composition of the central bank’s assets without a change in the monetary base, preserving independence of monetary policy from exchange-rate management.

The Problem Without Sterilisation

When a central bank intervenes in the foreign exchange market without sterilising, the operation mechanically alters the money supply. If the Swiss National Bank buys US dollars, paying with Swiss francs, the Swiss monetary base expands — new francs have been created and injected into the banking system. This is an unsterilised intervention: it tightens monetary conditions for the US (dollars are withdrawn from circulation) and loosens them for Switzerland (francs are injected).

For a central bank that wants to manage its currency without shifting monetary policy, this linkage is a problem. If the Swiss franc is appreciating too rapidly — damaging exporters — the SNB might want to buy foreign currency to weaken the franc. But the resulting expansion of the Swiss money supply could fuel inflation, conflicting with the central bank’s price-stability mandate. An unsterilised intervention forces a choice: defend the currency or control inflation.

Sterilisation breaks this link, allowing a central bank to pursue exchange-rate objectives independently of monetary goals.

How Sterilisation Works: Two-Step Process

Step 1: The Initial Intervention

The central bank enters the foreign exchange market. Assume the Swiss franc is overvalued. The SNB decides to buy US dollars, offering francs. The transaction is:

SNB receives: $1 billion USD
SNB pays: CHF 1 billion

On the SNB’s balance sheet, foreign exchange reserves rise by $1 billion, and the monetary base (francs in circulation and in bank accounts) rises by CHF 1 billion. The franc supply in the market increases, putting downward pressure on the exchange rate — the intended outcome.

However, that CHF 1 billion is new money in the banking system, expanding the monetary base.

Step 2: The Sterilising Offset

To undo the monetary expansion, the SNB immediately conducts an open market operation: it sells domestic securities (typically government bonds or bills) from its portfolio.

SNB receives: CHF 1 billion (from banks or investors buying the bonds)
SNB pays: Domestic bonds worth CHF 1 billion

This operation drains CHF 1 billion from the banking system, exactly offsetting the money created by the forex purchase. The monetary base returns to its original level.

Net Result

The SNB’s balance sheet has changed: it holds $1 billion more in foreign exchange reserves and $1 billion less in domestic bonds. But the total monetary base is unchanged. The franc has weakened (the intended outcome), and monetary policy remains on its original path (inflation and interest-rate targets unaffected).

Why Central Banks Sterilise

Sterilisation preserves monetary policy autonomy. A central bank can pursue its exchange-rate objectives without being forced to abandon its domestic inflation or growth target. Without sterilisation, defending a currency often means accepting either unwanted monetary tightening (if intervening to support your currency by selling it requires you to tighten policy) or loosening (if supporting your currency requires you to ease policy).

Sterilisation is also politically useful. A country that wants to weaken its currency without the appearance of “loosening” monetary policy can sterilise the intervention. The currency weakens (helping exporters), but the central bank can claim monetary policy is unchanged.

From a financial stability perspective, sterilisation also contains the expansion of foreign exchange reserves. Without it, a central bank supporting its currency during a crisis would accumulate vast quantities of foreign assets while simultaneously expanding the domestic money supply, potentially destabilizing prices.

Practical Mechanics: The Securities Market

In reality, sterilisation involves the repurchase agreement (repo) market and open market operations. A central bank doesn’t usually sell securities outright; instead, it may:

• Execute a matched repo: borrow domestic currency against domestic securities, draining the money supply temporarily.
• Conduct an outright sale of bills or bonds, receiving domestic currency that is then retired.
• Use existing tools like the discount window (lending domestic currency against collateral), effectively absorbing liquidity.

The technical details vary by central bank, but the principle is constant: drain liquidity equal to the amount injected by the forex operation.

Effectiveness: Mixed Evidence

The question of whether sterilised interventions actually work — that is, whether they meaningfully influence exchange rates — is contested among economists. Empirical evidence is mixed.

In theory, a sterilised intervention should not work if financial markets are efficient and large. If the SNB buys US dollars, the dollars become scarcer, which should weaken the franc. But simultaneously, the SNB is selling domestic bonds, which increases their supply and lowers their price (raising their yield). The higher yield on francs and franc assets should attract foreign investors, pushing the franc back up. The two effects could cancel out.

Empirically, however, some sterilised interventions do appear to influence exchange rates, particularly when:

• The central bank’s intervention is large relative to daily foreign exchange volumes.
• The market expects the central bank to sustain the intervention (strong resolve and forward guidance).
• Multiple central banks intervene in the same direction (coordination).
• The currency is not in a deep crisis or subject to severe political uncertainty.

The Swiss National Bank’s 2009–2015 intervention against franc appreciation was formally sterilised (the SNB expanded its balance sheet with foreign assets but offset the monetary impact through sales of francs and bonds to other central banks). It eventually worked, though the franc did strengthen again after 2015 when the SNB abandoned the floor.

Relationship to Monetary Policy

Sterilisation allows a central bank to separate exchange-rate intervention from monetary policy. If unsterilised, every forex operation would shift the monetary stance. With sterilisation, the central bank’s interest-rate target and money supply goals remain independent of currency management.

However, there are limits. If a central bank sterilises a massive intervention and simultaneously tries to maintain very low interest rates, the two goals can conflict over time. The accumulation of foreign reserves (and the offsetting decline in domestic assets) shifts the composition of the central bank’s balance sheet. If the foreign currency depreciates or defaults risk rises, the central bank can face losses.

Also, sterilisation is labor-intensive and costly if the central bank must pay high interest rates to drain liquidity (e.g., by selling bonds at high yields). A central bank that sterilises while facing high inflation pressures may find it difficult to keep supply-side inflation under control.

Modern Context and Alternatives

In the era of floating exchange rates and large, deep capital markets, sterilised intervention is less common than it once was. The currency value adjusts quickly via capital flows, making it hard for a central bank to sustain an intervention without inflicting costs on its balance sheet or accepting inflation.

Central banks in developed economies (US, ECB, Bank of Japan) rarely intervene in their forex markets anymore, preferring to let the market set the exchange rate. Developing economy central banks and countries facing currency crises are more likely to intervene, and they often sterilise to protect their monetary policy mandate.

The Swiss National Bank stands out as a developed-economy central bank that actively intervenes, historically sterilising to maintain franc strength while keeping monetary policy accommodative.

See also