Central Bank Sterilization

By L. Randall Wray [via CFEPS]

There is a great deal of confusion over international “flows” of currency, reserves, and finance, much of which results from failure to distinguish between a floating versus a fixed exchange rate. For example, it is often claimed that the US needs “foreign savings” in order to “finance” its persistent trade deficit that results from “profligate US consumers” who are said to be “living beyond their means”. Such a statement makes no sense for a sovereign nation operating on a flexible exchange rate. In a nation like the US, when viewed from the vantage point of the economy as a whole, a trade deficit results when the rest of the world (ROW) wishes to net save in the form of dollar assets. The ROW exports to the US reflect the “cost” imposed on citizens of the ROW to obtain the “benefit” of accumulating dollar denominated assets. From the perspective of America as a whole, the “net benefit” of the trade deficit consists of the net imports that are enjoyed. In contrast to the conventional view, it is more revealing to think of the US trade deficit as “financing” the net dollar saving of the ROW—rather than thinking of the ROW as “financing” the US trade deficit. If and when the ROW decides it has a sufficient stock of dollar assets, the US trade deficit will disappear.

It is sometimes argued that when the US experiences a capital account surplus, the dollars “flowing in” will increase private bank reserves and hence can lead to an expansion of private loan-and-deposit-making activity through the “money multiplier”. However, if the Fed “sterilizes” this inflow through open market sales, the expansionary benefits are dissipated. Hence, if the central bank can be persuaded to avoid this sterilization, the US can enjoy the stimulative effects.

Previous analysis should make it clear that sterilization is not a discretionary activity. First it is necessary to understand that a trade deficit mostly shifts ownership of dollar deposits from a domestic account holder to a nonresident account holder. Often, reserves do not even shift banks as deposits are transferred from an account at a US branch to an account at a foreign branch of the same bank. Even if reserves are shifted, this merely means that the Fed debits the accounts of one bank and credits the accounts of another. These operations will be tallied as a deficit on current account and a surplus on capital account. If treasury or central bank actions result in excess reserve holdings (by the foreign branch or bank), the holder will seek earning dollar-denominated assets—perhaps US sovereign debt. US bond dealers or US banks can exchange sovereign debt for reserve deposits at the Fed. If the net result of these operations is to create excess dollar reserves, there will be downward pressure in the US overnight interbank lending rate. From the analysis above, it will be obvious that this is relieved by central bank open market sales to drain the excess reserves. This “sterilization” is not discretionary if the central bank wishes to maintain a positive overnight rate target. Conversely, if the net impact of international operations is to result in a deficit dollar reserve position, the Fed will engage in an open market purchase to inject reserves and thereby relieve upward pressure that threatens to move the overnight rate above target.

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