Monetary Operations by Central Banks

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Monetary Operations by Central Banks

All central banks and the U.S. Federal Reserve System (FRS) as well, affect the foreign exchange markets changing discount rates and performing the monetary operations (as interventions and currency purchases).

For the foreign exchange operations most significant are repurchase agreements ("repos") to sell the same security back at the same price at a predetermined date in the future (usually within 15 days), and at a specific rate of interest. This arrangement amounts to a temporary injection of reserves into the banking system. The impact on the foreign exchange market is that the national currency should weaken. The repurchase agreements may be either customer repos or system repos. Matched sale-purchase agreements are just the opposite of repurchase agreements. When executing a matched sale-purchase agreement, a bank or the FRS sells a security for immediate delivery to a dealer or a foreign central bank, with the agreement to buy back the same security at the same price at a predetermined time in the future (generally within 7 days). This arrangement amounts to a temporary drain of reserves. The impact on the Forex market is that the national currency should strengthen.

Monetary operations include payments among central banks or to international agencies. In addition, the FRS has entered a series of currency swap arrangements with other central banks since 1962. Also, payments to the World Bank or the United Nations are executed through central banks.

Intervention in the United States foreign exchange markets by the U.S. Treasury and the FRS is geared toward restoring orderly conditions in the market or influencing the exchange rates. It is not geared toward affecting the reserves.

There are two types of foreign exchange interventions: naked intervention and sterilized Intervention. Naked intervention, or unsterilized intervention, refers to the sole foreign exchange activity. All that takes place is the intervention itself, in which the Federal Reserve either buys or sells U.S. dollars against a foreign currency. In addition to the impact on the foreign exchange market, there is also a monetary effect on the money supply. If the money supply is impacted, then consequent adjustments must be made in interest rates, in prices, and at all levels of the economy. Therefore, a naked foreign exchange intervention has a long-term effect.

Sterilized intervention neutralizes its impact on the money supply. As there are rather few central banks that want the impact of their intervention in the foreign exchange markets to affect all corners of their economy, sterilized interventions have been the tool of choice. This holds true for the FRS as well. The sterilized intervention involves an additional step to the original currency transaction. This step consists of a sale of government securities that offsets the reserve addition that occurs due to the intervention. It may be easier to visualize it if you think that the central bank will finance the sale of a currency through the sale of a number of government securities. Because a sterilized intervention only generates an impact on the supply and demand of a certain currency, its impact will tend to have a short-to medium-term effect.

Board of Governors of the Federal Reserve System

  • Bank of England
  • European Central Bank
  • Bank of Japan
  • Reserve Bank of Australia
  • Swiss National Bank