Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Spend Billions Defending Their Currency
Transcript
- Lucas: In October 2022, the Bank of Japan spent roughly 70 billion dollars in a single day buying yen. That is still a record for any central bank intervention, and it didn't stop the yen from weakening further over the next few months. Luna: Seventy billion in one day. That's more than the entire GDP of some countries. And it didn't work? Lucas: It slowed the decline temporarily, but the fundamental forces were stronger. That's the problem with currency intervention—you're swimming against the tide if your monetary policy is diverging from others. The Bank of Japan was still holding negative rates while the Fed was hiking aggressively. So the carry trade was massive. Luna: So the intervention is just buying your own currency with foreign reserves, right? How does that actually work? Lucas: That's the core mechanic. A central bank sells its foreign exchange reserves—usually dollars—and buys its own currency. That demand pushes the domestic currency higher, at least in the short term. But there's a crucial distinction: sterilized versus unsterilized intervention. And that determines whether the intervention affects the money supply or not. Luna: Sterilized means you offset the sale of reserves with an open market operation, so the monetary base stays the same. Unsterilized, you let the reserves drain reduce the money supply. Which do central banks actually use? Lucas: Almost always sterilized. Central banks want to target interest rates, not money supply. If they sell reserves to buy yen, that drains bank reserves from the system, which could push up short-term rates. So they buy domestic bonds to inject those reserves back in. The classic example is the Bank of Japan—they sterilized every yen they bought. But there's a cost: they're swapping liquid foreign assets for domestic bonds that might yield less, or even have negative yield in Japan's case. Luna: So they're booking a potential loss on their balance sheet if the yen weakens further. That's a political risk. Lucas: Exactly. And the bigger risk is credibility. If the market thinks you'll run out of reserves, your intervention is just a speed bump. That's what happened to the Bank of England during the 1992 Black Wednesday crisis. They spent billions defending the pound, but eventually ran out of ammunition and had to let it float. Luna: But the Bank of Japan had enormous reserves—over a trillion dollars at the time. Why didn't they use more? Lucas: They did, actually. Between 2022 and early 2024, they spent about 70 billion dollars in multiple rounds. But each intervention gave only a temporary reprieve. The key is that sterilized intervention doesn't change the underlying interest rate differential. As long as the carry trade remains profitable, the market will keep selling yen. The only way to truly stop a currency decline is to raise interest rates or change monetary policy. Luna: So intervention is more like a signal? A way to say 'we are watching'? Lucas: Yes, it can be used to break short-term speculative momentum, particularly if the market is already expecting a reversal. The Swiss National Bank is a master of that. In 2011, they pegged the franc to the euro at one point two francs per euro. That was a massive, unsterilized intervention—they effectively created francs to buy euros, expanding their balance sheet massively. It worked for three years, but when they abandoned the peg in 2015, the franc soared and they took huge losses. Luna: Which shows intervention is a high-risk gamble. But don't some emerging markets have no choice? If your currency is collapsing and you have dollar-denominated debt, you have to defend it. Lucas: That's the other side. For countries like Turkey, defending the lira became existential. In 2021–2022, the central bank spent billions of dollars from its reserves, but President Erdogan was pressuring them to keep interest rates low. So the intervention was fighting against both market forces and policy. Ultimately, they blew through reserves and the lira still lost 80 percent of its value. That's the danger: you can waste your war chest and be left with nothing. Luna: It's fascinating how much coordination and analysis goes into these moves. You have to decide timing, size, whether to go public, and how to sterilize. If you find this kind of behind the scenes central banking interesting, you might also appreciate that this show is ad-free thanks to listeners who support us. We keep it that way because we think economics should be accessible. If you'd like to help, you can find us at buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small gesture that keeps the podcast independent. And honestly, we love doing this, so support is just a bonus. Anyway, back to the mechanics—let's talk about what happens after the intervention: the data on effectiveness. Luna: What do the studies show? Does sterilized intervention actually move exchange rates? Lucas: A lot of academic work has been done, especially by researchers at the Bank for International Settlements. The consensus is that sterilized intervention can affect exchange rates in the very short term—hours to a few days—but its ability to change the trend is limited. One study found that for advanced economies, the success rate in turning the exchange rate direction is about 30 percent. For emerging markets, it's higher because markets are thinner, but the risks are also greater. Luna: So why do central banks keep doing it? Is it just for signaling? Lucas: Partly. But also, sometimes the alternative is worse. If a currency is overshooting due to panic, a well-timed intervention can calm markets. And there is evidence that intervention works better when it's coordinated with monetary policy—like when a central bank signals a future rate hike alongside the purchase. That's what the Bank of Japan did eventually in 2024: they ended negative rates, and the yen stabilized. Luna: So the real lesson is that intervention is not a substitute for sound macroeconomic policy. You can't prop up a currency forever if your fundamentals are out of whack. Lucas: Exactly. The Bank of Japan's interventions were a holding action until they could pivot on policy. The Swiss National Bank's peg worked until it didn't. And Turkey's interventions just burned through reserves without addressing the root cause. So next time you hear a central bank has intervened, remember: they're not just buying currency; they're making a high-stakes bet against the market, and the odds are often stacked against them.