Japanese Intervention was Not Sterilized – What Does that Mean?

The Bank of Japan said explicitly last night that their intervention will NOT be sterilized. This is VERY good because it gives their intervention efforts a greater chance of succeeding.

Intervention by central banks is one of the most important short-term and long-term fundamental drivers in the currency market. For short-term traders, intervention can lead to sharp intraday movements on the scale of 150 to 250 pips in a matter of minutes. For longer-term traders, intervention can signal a significant change in trend because it suggests that the central bank is shifting or solidifying its stance and sending a message to the market that it is putting its backing behind a certain directional move in its currency.

There are basically two types of intervention, sterilized and unsterilized. Sterilized intervention requires offsetting intervention with the buying or selling of government bonds, while unsterilized intervention involves no changes to the monetary base to offset intervention.

The intervention by the Japanese government in 2003-2004 was sterilized which is part of the reason why it was unsuccessful. The government sold Yen with money financed by the issuance of bills. When intervention is not sterilized, the money supply is increased because the funds used to sell Yen may be raised by printing money.

Many argue that unsterilized intervention has a more lasting effect on the currency than sterilized intervention and thankfully the latest intervention is not sterilized.

Quoting the Cleveland Federal Reserve who published a working paper titled Sterilized Intervention, Nonsterilized Intervention, and Monetary Policy in 2001:

Sterilized intervention is generally ineffective. Countries that conduct monetary policy using an overnight interbank rate as an intermediate target automatically sterilize their interventions. Unsterilized interventions can influence nominal exchange rates, but they conflict with price stability unless the underlying shocks prompting them are domestic in origin and monetary in nature. Unsterilized interventions, however, are unnecessary since standard open-market
operations can achieve the same result.

How is Intervention Sterilized?

According to the Cleveland Federal Reserve, this is how the sterilization of intervention is done:

Sterilization occurs automatically by virtue of the Federal Reserve’s operating procedure. The FRBNY’s Open Market Desk manages total reserves in the U.S. banking system in such a way as to achieve the federal funds target that the Federal Open Market Committee (FOMC) establishes in its monetary-policy deliberations. The FOMC actions are almost always taken with domestic objectives—inflation, business-cycle developments, financial fragility—in mind. Given its estimate of depository institutions’ demand for total reserves, the Desk manages the supply of reserves through open-market operations to keep the actual federal funds rate at the target. In the process, the Desk must take account of a number of factors that appear on the Federal Reserve’s balance sheet and that can affect the amount of reserves in the banking system at any time. Among these items are changes in the Treasury’s cash balances and changes in the Federal Reserve’s portfolio of foreign exchange. The Federal Reserve staff will attempt to estimate these on a day-to-day basis, but whether anticipated or not, the Fed will respond to them quickly in defense of the federal funds target. Consequently, intervention is never permitted to change reserves in a manner that is inconsistent with the day-to-day maintenance of the federal fund rate target. All central banks, including the Bank of Japan and the European Central Bank, that use an overnight, reserve-market interest rate as a short-term operating target necessarily sterilize their
interventions in this way.

The Federal Reserve has on occasion adjusted its monetary policy stance with an exchange market objective in mind, and it has sometimes intervened in the foreign exchange market while altering its federal funds target. Whether one refers to such interventions as nonsterilized or as a combination of a sterilized intervention in conjunction with a monetary policy change is inconsequential. In either case, the intervention is completely unnecessary since domestic open-market operations alone can achieve the same objective.

USD/JPY: What Happens When the Interest Rate Spread Goes Negative?

This is not the first time in recent history that US interest rates have fallen below Japanese levels. In the past 40 years, this has happened at least 5 times. The most recent time was in 1993.

The following chart illustrates how USD/JPY performs whenever the interest rate spread between the US and Japan dips below zero. As you can see, it almost always precedes a sharp drop in USD/JPY that lasts can last for a number of months.

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USD/JPY Hits 13 Year Lows: Will BoJ Intervene?

USD/JPY hit a 13 year low of 88.22 today after news that the bailout plan is not going happen before the new year. If you have been following my blog, I called for a move down to a new 13 year low Wednesday morning. At that time, USD/JPY was trading at 92.50-93.00. The currency pair has reversed violently after falling to 88.22.

Will the Bank of Japan Intervene?

A big question on everyone’s mind is Will the Bank of Japan intervene. Don’t expect BoJ intervention to happen anytime soon. As an export dependent nation, a strong currency is not in Japan’s best interest. However unlike in the past where the BoJ has intervened when USD/JPY fell below 105 and 100, we may not see any action by the Japanese government this time around. Since the problems are inherent in the US and the Eurozone, intervening at this time may be counterproductive for the Japanese. The only type of intervention that has ever worked is coordinated intervention. The BoJ will have a very tough time convincing the Americans to take any steps that would lead to further strength in the US dollar. The Japanese government needs to stand aside and allow the US and Eurozone governments to take their measures to spur growth and not strengthen the dollar for their own short term relief.

USD/JPY Chart from 12.10.08

USD/JPY

The Race to Zero Interest Rates

With the global economic downturn in full swing, one of the burning questions on everyone’s minds is who will be the first central bank to take interest rates to zero and how close will everyone else get?

We are in a global easing cycle and the varying aggressiveness of central banks around the world means that any country could be the first to see zero interest rates.

We expect December to be another active month for the foreign exchange market as central banks around the world take their interest rates to historically significant levels. There are 4 central banks with monetary policy decisions in the first week of December and all 4 are expected to cut interest rates. The closest to zero is the Bank of Japan, but having been there before, they are reluctant to revisit those levels. The US Federal Reserve and the Swiss National Bank have the second lowest interest rates. Both central banks are expected to continue to ease, but the Fed has been far more open about going to zero interest rates than the SNB. Realistically, Japan and the US will probably be the only ones to take rates all the way down to zero. Switzerland should be left with the second lowest interest rate when the dust settles followed by the Bank of England.

What Happens After Zero?
When a central bank runs out of room to cut interest rates, they resort to Quantitative Easing. This term was coined by the Bank of Japan in 2001 when interest rates were already at zero and the central bank stopped targeting the overnight call rate and turned to targeting a current account level. Their goal was to flood the Japanese financial system with liquidity by buying trillions of yen of financial securities including asset-backed instruments and equities.

It can be argued that the US has already engaged in Quantitative Easing as the government has recently announce plans to spend $800 billion to unfreeze the consumer and mortgage market. They have agreed to buy mortgage backed securities backed by government sponsored entities and could accelerate that if interest rates hit zero. Excess reserves have also increased significantly, driving the effective fed funds rate well below 0.5 percent. This would have been one of desired outcomes of quantitative easing. Last week, Fed vice chairman Donald Kohn said quantitative easing measures were under review at the central bank as normal contingency planning. The goal would be to encourage banks to lend more aggressively by coming in as a buyer at specified rates. Even though quantitative easing drove Japan into deflation, it was the key to turning around the economy and this is a risk that the US central bank may have to take.

Here’s where the major central banks stand and what is expected for the next meeting:

Federal Reserve – 50bp Cut Expected on 12/16

On October 29, the Federal Reserve took interest rates to 1 percent, which is near the record low reached in 2003 and 2004. While other countries have just started reacting aggressively to financial conditions, the Fed has been mounting cuts as far back as the middle of 2007. There has been no looking back since, as rates have been cut 425bp since 2007 and 250bp year to date. With interest rates near ultra low levels, the Federal Reserve has already resorted to unorthodox policy tools. More easing is expected with the markets torn between a 50 or 75bp rate cut in December. The FOMC statement will be particularly important this time around because the Fed will have the difficult decision of signaling a move to zero interest rates. In order to deal with this decision, they have expanded their monetary policy meeting from 1 to 2 days. Fed Chairman Ben Bernanke has remained dovish throughout the past few months which mean that another rate cut is practically guaranteed.

European Central Bank – 50bp Cut Expected on 12/04
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