The Swiss National Bank Must Raise Interest Rates By a Lot
Inflation is much above the SNB’s objective of 0-2%. As the Swiss economy can easily withstand tighter monetary policy, the SNB should focus squarely on restoring price stability. An end-of-year level of 2%, or perhaps even more, is justifiable given the economic outlook.
Interest rates in Switzerland are on their way up. That makes sense. Inflation at 3.5% is much above the objective of the Swiss National Bank of zero to 2% inflation, even though comparatively limited importance of fossil fuel in the Swiss energy mix had moderated its rise. No doubt the SNB is concerned by current inflation rates.
While it must take account of economic developments in setting policy, the Swiss economy can easily withstand tighter monetary policy. One reason is that Swiss labour markets are highly flexible. That was apparent after the abandonment of the exchange rate floor to the euro in 2015 when the franc surged in value but the unemployment rate hardly budged. The key factor is that Swiss exports are not highly sensitive to the exchange rate because of the type of advanced, high value-added products Switzerland sells abroad. And the franc does not appear to be obviously overvalued now.
Another reason is that mortgage lending has been prudent, despite surging housing prices. While higher interest rates will unavoidably cool the housing market, a sharp market downturn driven by borrower defaults seems entirely unlikely. That is a concern in other countries where interest rates are on their way up, but not in Switzerland.
Since monetary policy in Switzerland has few side-effects in terms of unemployment and economic activity but impacts on inflation, the SNB's monetary policy should focus squarely on restoring price stability. That is in contrast to the United States and the euro area, where tighter monetary policy often comes with higher unemployment and lower growth.
How much should the SNB raise interest rates? Many market participants appear to expect that the SNB will raise rates by 0.5% or 0.75% on 22 September and by another 0.5% in December to 1%. That, in my view, seems too modest.
While the SNB's rate setting committee meets quarterly to set policy, the ECB and the Fed meet eight times per year. The ECB, Fed and the SNB will all meet to consider policy in the middle of December, but the ECB and the Fed also meet at the end of October and early November, respectively. That suggests that the SNB should raise interest rates by more, perhaps much more, than the ECB and the Fed do now.
Since changes in the exchange rate of the franc have powerful effects on inflation, how much interest rates in the US and the euro area will rise in the coming months matters for the SNB’s decision. Market participants anticipate that the Fed will raise the federal funds rate by about 1.5% or even 2% by the end of the year and that the ECB, which has just increased interest rates by 0.75% in early September, will do so too, or perhaps even raise them a little more.
If the SNB raises rates by less than this, the franc may weaken, boosting inflation. That suggests that rates should be raised by at least 1.5% between now and December.
But with Swiss headline inflation at 3.5%, an target interest rate of 1.25% also seems too modest to lower inflation materially. An end-of-year level of 2%, or perhaps even more, is justifiable given the economic outlook.
Of course, if inflation remains stubbornly high in the euro area, leading the ECB to tighten policy by more than is now expected, Swiss interest rates may need to go higher. Conversely, if the euro area slips into a deep recession that lowers inflation, the need to push up interest rates in Switzerland will be reduced.
Overall, a large increase in interest rates by the SNB of at least 0.75% or by even 1% can be expected on 22 September. A similarly large increase might be decided in December, depending on how economic conditions evolve during the autumn. While this may seem like a radical change, it is warranted by economic conditions. And the SNB has shown repeatedly that it prefers dramatic policy changes and is not too concerned by market expectations.
Stefan Gerlach
