How do sterilized and unsterilized central bank interventions differ in their effect on exchange rates?

Central bank intervention in FX markets is a critical topic for CFA Level II Economics. The key distinction is whether the intervention changes the domestic money supply.

Unsterilized Intervention:

The central bank intervenes and allows the money supply to change.

Example — Weakening the domestic currency:

1. The Central Bank of Silverton (CBS) wants to weaken the Silverton Dollar (SLD)
2. CBS sells SLD and buys USD in the FX market
3. SLD money supply increases (more SLD in circulation)
4. This is equivalent to monetary easing
5. Domestic interest rates fall → capital outflows → SLD depreciates
6. Effective because it combines FX market intervention with a change in monetary conditions

Sterilized Intervention:

The central bank intervenes but offsets the money supply impact through open market operations.

Example — Same scenario, sterilized:

1. CBS sells SLD and buys USD in the FX market (SLD money supply increases)
2. CBS simultaneously sells domestic government bonds (absorbs the excess SLD)
3. Net effect on money supply: zero
4. Interest rates unchanged, no monetary policy signal
5. Less effective because the fundamental driver (money supply/interest rates) hasn't changed

Does Sterilized Intervention Work?

The evidence is mixed. Two channels through which it might work:

1. Signaling channel — The intervention signals the central bank's intent to the market. If traders believe the central bank will eventually use unsterilized intervention or rate changes, the sterilized intervention acts as a credible threat.

1. Portfolio balance channel — By changing the relative supply of domestic vs. foreign bonds available to private investors, sterilized intervention may affect risk premiums. However, this requires imperfect substitutability between domestic and foreign assets.

Practical Example:

In 2011-2015, the Swiss National Bank (SNB) maintained a floor of 1.20 CHF/EUR. They intervened massively, buying EUR and selling CHF. When they abandoned the peg in January 2015, the CHF appreciated nearly 30% in minutes, demonstrating the pent-up pressure from sterilized intervention.

Factors Affecting Intervention Success:

• Size relative to market — Daily FX turnover exceeds $7 trillion. A $5 billion intervention is a drop in the ocean.
• Coordination — Coordinated intervention by multiple central banks is more effective.
• Direction — Leaning against the wind (fighting the trend) is less effective than leaning with the wind.
• Credibility — Markets must believe the central bank will follow through.

Exam tip: CFA Level II typically asks whether an intervention will be effective. Unsterilized intervention aligned with monetary policy fundamentals has the strongest impact. Sterilized intervention alone rarely moves rates persistently unless it carries a strong signaling component.

Learn more about central banking and FX markets in our CFA Level II economics section on AcadiFi.