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, think it was a terrible decision - but because I so far have 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 dissatisfied with how its 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 has no problem 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 - let's implement a massive tightening of monetary conditions and see what will happen." And what happened? Everybody in the SNB management screamed "Great idea! Let's 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 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 the Swiss franc. That said, over the past year or so, I have become increasingly skeptical 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 be 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 policyinstrument 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 announce 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 in the future it would use the 'mid-point' of the fluctuation band as the de facto 'instrument' for implementing monetary policy so as to signal that the mid-point could be changed always to hit the ultimate monetary policy target - for example 2% (expected) inflation.

by Lars Christensen,