The SNB is stuck in an environment of too low inflation. It should adjust its monetary policy to raise inflation expectations, and it should embrace greater frankness about the role of the exchange rate in its policy mix.
Today the SNB Observatory, which we have established to contribute to the debate on monetary policy in Switzerland, is releasing a report on «lowflation». The report proposes several changes to the Swiss National Bank's monetary policy strategy to help it end the current patch of too low inflation. The proposed changes aim to raise expected inflation. We also think the SNB needs to embrace greater frankness about the role of the exchange rate in SNB policy.
The SNB has a long and highly successful history of maintaining very low inflation. But too much of a good thing is not necessarily great. The SNB’s reputation for being tough on inflation has, paradoxically, now turned into a problem.
Like other central banks, the SNB manages monetary policy by setting interest rates. The rate it sets depends on the inflation environment, the state of the business cycle and the «neutral real interest rate», which is outside central banks’ control.
The latter has declined across the world in recent decades, partly due to the ageing of society and changes in productivity. This has forced central banks in all advanced economies to cut interest rates to increasingly lower levels.
But a situation in which both inflation and the neutral real rate are very low is problematic. Central banks’ policy rates will then typically be so close to zero that if a recession occurs, they may be forced to set negative interest rates, perhaps for an extended period of time.
This is a particularly serious problem for the SNB since Swiss inflation has historically been lower than inflation elsewhere. The SNB has now kept interest rates at -0.75%, lower than any other central bank, for more than six years. The SNB may be able to cut interest rates further, but not by much: interest rate policy is nearly exhausted. With little room to cut interest rates further, the ability of the SNB to avoid deflation or to support the economy in a slump is curtailed.
Clinging on to the current strategy is risky. Other central banks are adapting to the new realities. The Federal Reserve has just completed a strategy review, and the European Central Bank is currently conducting one. It is time for the SNB to do the same.
We believe that the SNB should take two steps.
First, it should seek to raise inflation expectations.
Higher expected inflation will put upward pressure on inflation. While inflation expectations are largely shaped by inflation rates in recent years, the SNB can influence them. It must convince the public that inflation will on average be higher in the future than it has been in the recent past.
How can it do so? A good place to start is the definition of price stability, the SNB’s primary objective, an inflation rate of less than 2%. Since a «protracted decline of the price level» conflicts with price stability, in practice price stability means 0% to 2% inflation. This is too vague and too low. Rather than having a «zone of indifference», a point objective for inflation will help focus expectations.
Since a 2% objective has emerged as a global standard, the SNB should adopt it as well. In doing so, it would join many central banks from small open economies, including Canada, New Zealand and Sweden.
Of course, monetary policy is too blunt an instrument for the SNB to hit a point objective every month or even every year. Instead, the objective should be met on average over the medium term so that a period of inflation below the objective should be offset by a period of inflation above the objective. That will prevent inflation expectations from falling too low and reduce the likelihood that the SNB will have to set negative interest rates.
This new approach of targeting an average inflation rate was adopted last year by the US Federal Reserve as part of its strategy review and is likely to become a worldwide standard. The SNB should adopt it.
In addition, the SNB needs to have better information about inflation expectations in order to be able to manage it. One technique for measuring expectations involves comparing the yields on inflation-indexed and nominal bonds. But Switzerland has no market for inflation-indexed bonds, arguably because inflation has been so low.
Another approach is to use surveys. In Switzerland, surveys are conducted by SECO and by the CFA Society in association with Credit Suisse, which the SNB reports in its publications. However, the SNB only indicates which proportions of respondents see inflation rising or declining. Qualitative surveys are not enough.
Yet another approach is to use econometric models. This what the SNB does. Using its own models, it publishes a quarterly inflation forecast, which assumes no change in the current interest rate. The intended purpose is to guide expectations. While the intention is good, the guidance is vague, at best. The forecasts have also systematically overpredicted inflation, and are therefore disregarded by much of the public.
The SNB should be more ambitious. The Federal Reserve produces and publishes an index of survey-based inflation expectations. The ECB conducts a quarterly survey of professional forecasters and, since the beginning of 2020, a consumer survey. The Bank of Japan conducts several surveys every year on a wide variety of topics that are relevant to monetary policy. The SNB too should start conducting and publishing quantitative inflation expectation surveys on a regular basis. Alternatively, the SNB can outsource this task to, for instance, SECO or KOF.
Furthermore, to raise inflation expectations, the SNB must make it much clearer in speeches and publications that it views the current rate of inflation, -0.5% year-over-year, as too low and that it is a problem. The public must be made to understand that the SNB is committed to ending deflation, which is a precondition for exiting negative interest rates.
Without clear, repeated and unambiguous statements to the effect that inflation is unacceptably low, the public will form expectations on the basis of the SNB’s reputation of aiming for inflation below that of most other central banks. Many will conclude that the SNB is not worried about occasional deflationary periods.
In the current situation, for instance, it should announce that interest rates will not rise until inflation overshoots its objective for inflation to compensate for the years of deflation.
Making these changes may not be enough to end the present patch of too low inflation, but they will help. There is no reason to wait.
The second step the SNB should take is to recognize that the policy rate has been stuck at –0.75% for more than six years and is no longer a policy instrument. In contrast to its official strategy, the SNB does not implement policy through the interest rate, but instead uses the exchange rate as an intermediate objective.
Since the global financial crisis erupted a little more than a decade ago, triggering very large inflows into Swiss francs, the strategy has effectively changed. The SNB has intervened massively in the foreign exchange market because it greatly cares about the value of the franc. In 2015, it abandoned the 1.20 floor vis a vis the euro, established in 2011, because it was forced to heavily intervene in the foreign exchange market. Yet, this did not alleviate the need to operate in the foreign exchange market.
The SNB should recognize that its focus on the exchange rate requires formalizing this strategic change. How can that best be done? One possibility is to peg the franc to the euro. Given the safe haven status of the franc, Swiss interest rates would have to fall below those in the euro area. In addition, the long on-going trend appreciation of the real exchange rate would occur through higher inflation in Switzerland than in the euro area rather than through a nominal appreciation of the Swiss franc. While that would be helpful now, when euro area inflation has returned to 2% Swiss inflation would be above that level. Fixing the Swiss franc to the euro exchange rate is therefore not a solution.
An alternative is a crawling peg framework much like that of Singapore. In such a system, the SNB would announce a desired rate of change of the franc for the following quarters and use foreign exchange market interventions and interest rate changes, when that become possible again, to nudge it in the right direction.
Such a shift in the policy framework would not involve a fundamental change in strategy. However, providing guidance to the market by declaring a path for the exchange rate is likely to engender stabilizing expectations, meaning that less intervention is needed to steer the exchange rate. That would be helpful.
Once economic recovery has been achieved in and outside of Switzerland, it would announce what path of the exchange rate is, in its view, likely to achieve the 2% inflation objective, and use interest rates as well as supporting foreign exchange intervention to achieve it. That path is likely to entail a slow nominal appreciation of the Swiss franc although there may be periods when a slow nominal depreciation is needed.
While the SNB may initially have judged that the current situation in which the policy rate is maintained at –0.75% and the exchange rate serves as an intermediate target will be temporary, we believe that there is a serious risk of too low inflation becoming a permanent feature of the Swiss economy. While the formulation of a new strategy in which the exchange rate is an intermediate target requires a deeper analysis, an open mind about the role of the exchange rate is called for.
Summing up, the SNB is in a sticky situation, caused by the decline in the neutral interest rate and its historical preference for keeping inflation below that of most countries. As a consequence, the current strategy based on interest rate policy is neither usable nor, in fact, used. Moving ahead, the SNB needs to raise inflation expectations, and it should admit that the exchange rate has become a de facto intermediate target.
This article is co-authored by Stefan Gerlach (Chef Economist at EFG Bank), Yvan Lengwiler (Professor of Economics at University of Basel) and Charles Wyplosz (Professor Emeritus of Economics at The Graduate Institute, Geneva). They are the founders of the SNB Observatory.