What the SNB should have done
I have got a lot of questions about what I think about the Swiss central bank’s (SNB) decision last week to give up its ‘floor’ on EUR/CHF - effectively revaluing the franc by 20% - and I must admit it has been harder to answer than people would think. Not because I in anyway think it was a good decision – I as basically everybody else thinks it was a terrible decision – but because I so far has been unable to understand how what I used to think of as one of the most competent central banks in the world is able to make such an obviously terrible decision. One thing is that the SNB might have been dissatisfies with how it’s policy was working – and I would agree that the policy in place until last week had some major problems and I will get back to that – but what worries me is that the SNB instead of replacing its 120-rule with something better seems simply to have given up having any monetary policy rule at all. It is clear that the SNB’s official inflation target (0-2%) really isn’t too important to the SNB. Or at least it is a highly asymmetrical target where the SNB apparently have no problems if inflation (deflation!) undershoots the target on the downside. At least it is hard to think otherwise when the SNB last week effectively decided to revalue the Swiss franc by 20% in a situation where we have deflation in Switzerland. Try to imagine how this decision was made. One day somebody shows up in the office and says “we are facing continued deflation. That is what the markets, professional forecasters and our own internal forecasts are telling us very clearly. So why not test economic theory – lets implement a massive tightening of monetary conditions and see what will happens”. And what happened? Everybody in the SNB management screamed “Great idea! Lets try it. What can go wrong?” Yes, I am still deeply puzzled how this happened. Switzerland is not exactly facing hyperinflation – in fact it is not even facing inflation. Rather deflation will now likely to deepen significantly and Switzerland might even fall into recession. What was wrong with the ‘old’ policy? When the SNB implemented its policy to put a ‘floor’ under EUR/CHF back in 2011 I was extremely supportive about it because I thought it was a clever and straightforward way to curb deflationary pressures in the Swiss economy coming from the escalating demand for Swiss franc. That said over the past year or so I have become increasingly sceptical about the policy because I think it was only a partial solution and it has become clear to me that the SNB had failed to articulate what it really wanted to achieve with the policy. Unfortunately I didn’t put these concerns into writing – at least not publicly. Therefore let me now try to explain what I think was wrong with the ‘old’ policy – the 120-floor on EUR/CHF. At the core of the problem is that the SNB really never made it clear to itself or to the markets what ultimate nominal target it has. Was the SNB targeting the exchange rate, was it targeting a money market interest rate (the key policy rate) or was it targeting inflation? In fact it was trying to do it all. And we all know that you cannot do that – it is the Tinbergen rule. You cannot have more targets than you have instruments. The SNB only has one instrument – the money base – so it will have to focusing on only one nominal target. The SNB never articulated clearly to the markets, which of the three targets – the exchange, the interest rate or inflation – had priority over the others. This might work in short periods and it did. As long as the markets thought that the SNB would be willing to lift the EUR/CHF-floor even further (devalue) to hit its 2% inflation target there was no downward (appreciation) pressure on EUR/CHF and here the credibility of the policy clearly helped. Hence, there is no doubt that the markets used to think that the floor could be moved up – the Swissy could be devalued further – to ensure that Switzerland would not fall into deflation. However, by its actions it has become increasingly clear to the markets that the SNB was not about to lift the floor to fight deflationary pressures. As a consequence the credibility of the floor-policy has increasingly been tested and the SNB has had to intervene heavily in the FX market to “defend” the 120-floor. A proposal for a credible, rule-based policy that would work My proposal for a policy that would work for the SNB would be the following: First, the SNB should make it completely clear what its money policy instrument is and what intermediate and ultimate monetary policy target it has. It is obvious that the core monetary policy instrument is the money base – the SNB’s ability to print money. Second, in a small-open economy particularly when interest rates are at the Zero Lower Bound (ZLB) it can be useful to use the exchange rate as an intermediate target – a target the central bank uses to hit its ultimate target. This ultimate target could be a NGDP level target, a price level target or an inflation target. Second, when choosing its intermediate target it better rely on the support of the markets – so the SNB should announce that it will adjust its intermediate target to always hit its ultimate target (for example the inflation target.) In this regard I think it would make a lot of sense using the exchange rate – for example EUR/CHF or a basket of currencies – as an intermediate and adjustable target. By quasi-pegging EUR/CHF to 120 the SNB left the impression that the FX ‘target’ was the ultimate rather than an intermediate target of monetary policy. By stating clearly that the exchange rate ‘target’ is only a target implemented to hit the ultimate target – for example 2% inflation – then there would never be any doubt about what the SNB would trying to do with monetary policy. I think the best way to introduce such an intermediate target would have been to announced that for example the EUR/CHF floor had been increased to for example 130 – to signal monetary policy was too tight at 120 – but also that the SNB would allow EUR/CHF to fluctuate around a +/-10% fluctuation band. At the same time the SNB should announce that it in the future would use the ‘mid-point’ of the fluctuation band as the de facto ‘instrument’ for implementing monetary policy so to signal that the mid-point could be changed always to hit the ultimate monetary policy target – for example 2% (expected) inflation. That would mean that if inflation expectations were below 2% then the Swiss franc would tend to depreciate within the fluctuation band as the market (rightly) would expect the SNB to move the mid-point of the band to ensure that it would hit the inflation target. This would also mean that there would be a perfect ‘ordering’ of targets and instruments. The expectations for inflation relative to the inflation target would both determine the expectations for the development in the exchange and what intermediate target SNB would set for EUR/CHF. This would mean that under normal circumstances where SNB’s regime is credible the market would effectively implement SNB policy through movements in the exchange rate within the fluctuation band. As a consequence the SNB would rarely have to do anything with the money base. Of course one can of course think of periods where the SNB’s credibility is tested – for example if a spike global risk aversion causes massive inflows into CHF and push the CHF stronger even if inflation expectations are below the inflation target. That said the SNB would never have to give up “defending” CHF against strengthening as the SNB after all has the ability to print all the money it needs to defend the peg. Of course this is the ability that has been tested recently, but I believe that the appreciation pressure on CHF has been greatly increased by the SNB failure to move up the target in response to the clear undershooting of he inflation target. Hence, the reluctance to respond to deflationary pressures really has undermined the peg. Had the SNB moved up the EUR/CHF peg to 130 or 140 six months ago then there would not have been the appreciation pressures on the CHF we have seen and the SNB would not have had to expand its balance sheet as much as have been the case. The 'regime' I have outlined above is any many ways similar to Singapore’s monetary regime where the monetary authorities use the exchange rate rather than interest rates to implement monetary policy. In such a regime the central bank allows interest rates to be completely market determined and the central bank would have no policy interest rate. This would have that clear advantage that there would never be any doubt what target the SNB would be trying to hit and how to hit it. This of course is contrary to the ‘old’ regime where the SNB effectively tried to have both an exchange rate target, an interest rate target and the inflation target. This inherent internal contradiction in the system I believe is the fundamental reason why SNB’s management felt it had to give it up. Unfortunately the SNB so far has failed to put something else instead of the old regime and we now seem to be in a state of complete monetary policy discretion. I hope that the SNB soon will realise that monetary policy should be rule-based and transparent. My suggestion above would be such a regime. Update: I realise that I really should have dedicated this blog post to Irving Fischer, Lars E. O. Svensson, Bennett McCallum, Robert Hetzel and Michael Belongia. Their work on monetary and exchange policy greatly influenced the thinking in the post.