What a central bank can and cannot do to its currency

"The central bank will step in" is the standard reassurance whenever a currency moves sharply. It is sometimes true. Understanding when it is true, and when it is wishful thinking, comes down to knowing which tools exist and what each one can reach.

The interest rate

This is the strongest instrument, and it is not aimed at the exchange rate at all.

When a central bank raises its policy rate, holding assets in that currency pays more. Capital moves toward better-paying currencies, demand for the currency rises, and it tends to strengthen. Cut, and the reverse pressure applies.

Two qualifications matter more than the rule itself.

The first is that what counts is the difference between countries, not the level. A currency does not strengthen because rates went up; it strengthens because rates went up more than elsewhere, or more than the market expected. If everyone anticipated the rise, the move happened in advance.

The second is that the exchange rate is rarely the target. The Federal Reserve, the ECB and the Bank of England set rates against inflation and employment mandates. The currency effect is a by-product they live with, not an objective they steer. Only a small number of central banks — Switzerland is the clearest case in Europe — treat the exchange rate itself as a central variable, and they say so.

Intervention

The direct tool: the central bank enters the market and buys or sells its own currency against reserves.

It works, and the effect is often immediate and large. Japan's finance ministry has repeatedly instructed the Bank of Japan to intervene when the yen has fallen quickly, and each time the move on the day was visible from a distance. What intervention rarely does is change where a currency ends up over months. It buys time, breaks a one-way move, and signals that somebody is watching.

The literature distinguishes sterilised intervention, where the domestic money supply is left unchanged, from unsterilised, where it is not. Unsterilised intervention has the larger and more lasting effect, because it is really a monetary policy change wearing different clothes.

Words

Cheaper than either of the above, and sometimes as effective. A sentence in a press conference about "close attention to excessive volatility" can move a rate by a full percent, because traders price in the possibility of what has just been hinted at.

Verbal intervention only works while it is credible. A central bank that talks repeatedly and never acts stops being listened to.

The asymmetry that decides everything

Here is the part that explains every currency defence that has ever failed.

A central bank can weaken its own currency indefinitely. To sell your own currency you create it, and there is no limit on how much you can create. That is why ceilings, in principle, can be held for a long time.

A central bank can only strengthen its currency while its reserves last. Buying your own currency means selling foreign assets, and those are finite. Once the market suspects the reserves are running low, the pressure intensifies rather than easing — everyone wants to sell before the defence breaks.

That asymmetry has a history. Britain left the European Exchange Rate Mechanism on 16 September 1992 after a day of spending reserves and raising rates against a market that did not believe the peg. And the ceiling case has its own ending: the Swiss National Bank held a floor of 1.20 francs per euro from September 2011 until 15 January 2015, when it abandoned it without warning and the franc jumped in minutes. It could have kept printing francs. It chose not to, because the balance sheet it was accumulating had become a policy problem of its own.

What none of it can do

No central bank can hold a rate that fundamentals contradict. If inflation runs far above a trading partner's for years, no volume of intervention prevents the adjustment — it only decides whether the adjustment arrives gradually or in one step.

Nor can a central bank fine-tune a floating rate. It can lean against a move, smooth a disorderly day, and shift the odds. It cannot choose a number.

What this means when you are changing money

Very little on any given day, and quite a lot over a year.

If a currency is formally managed within a band, its behaviour is a description of policy rather than a market outcome, and it will sit near where the policy puts it. If it floats, announcements from the central bank are among the few scheduled events that reliably produce movement — which is an argument for not converting a large amount in the minutes around a rate decision, and no argument at all for trying to guess the direction. On that, see whether tomorrow's rate can be known.