Swiss monetary policy: Thinking one step further

Author: | Published: 19 Oct 2018
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The normalisation of the interest rate level in the eurozone is only proceeding slowly – even slower than expected some months ago. As the monetary policy of the European Central Bank (ECB) is a critical parameter for the Swiss National Bank (SNB), this also implies a very gradual exit from the negative interest rate policy in Switzerland. We expect the SNB to only hike interest rates from September 2019 onwards, and only in 2020 do we expect the Swiss target rate to cross the zero mark for the first time since late 2014.

While the European economy is growing steadily and the ECB is in the process of monetary policy normalisation, it is necessary to think one step further. The expansion in the US is well advanced and is approaching its tenth anniversary. The upswing in the eurozone is already more than six years old. As the global recovery has been more gradual than in previous cycles, it could go on for some more years. But at some point, a downturn will hit the global economy and therefore Switzerland as well, prompting the SNB to expand monetary policy again.

Fighting the next downturn

Swiss target rates – nominal and real – are currently at a very low level, as shown on Chart 1. As we see only a very gradual normalisation of monetary policy in the years ahead, rates are likely to remain at a subdued level. But this also means that any monetary response to the next economic downturn will start from a very low interest rate level.

Chart 1: Swiss National Bank’s target rate: 3-month Libor

Source: Macrobond, UBS

This clearly differentiates the next cycle from previous ones. Nominal target rates were 3.5% at the beginning of the recession in 2001 and at nearly 3% in 2007. In the next downturn, target rates are unlikely to start much above 1%. In real terms, the differences are also significant. While real interest rates reached their peak at 2.5% in 2000 and stood at 2% in 2007, real money market rates are unlikely to become positive in the coming years.

By cutting nominal interest rates, the SNB has ensured an interest rate differential between the Swiss franc and the euro and thereby made the Swiss franc less attractive for investors. This is one important pillar of the SNB's current two-pillar strategy. The second pillar constitutes of foreign exchange (FX) market interventions. As a result of FX interventions, the SNB's balance sheet has increased rapidly in recent years. At the moment, the SNB has nearly CHF800 billion in foreign currency assets on its books.

Balance sheets cannot be expanded infinitely

An important question for Swiss monetary policy during the next downturn is how much leeway is left for applying the current instruments. With respect to the size of the balance sheet, there is no clear-cut upper limit. However, there are some considerations that suggest that the balance sheet cannot be expanded infinitely. First, a larger balance sheet means higher volatility in earnings. The balance sheet may become so large that possible losses could erase the SNB's equity position. The SNB can continue to operate even with negative equity, as the SNB cannot become illiquid. However, in the long term, a negative equity position could hurt the central bank's credibility as a stability-oriented institution. Second, political resistance is forming against further lengthening the SNB's balance sheet and may gain momentum if the SNB continues with asset purchases in the future.

Interest rates cannot be cut too deep into negative territory

Similar to the balance sheet expansion, there is no clear-cut lower limit for interest rates. In theory, the SNB has to stop cutting interest rates before they are so deep in negative territory that bank clients find it less costly to withdraw physical money from savings accounts and store CHF bills in safe deposit boxes or vaults. In such a case, a flight of cash from bank balance sheets into cash could endanger the stability of the Swiss banking system. However, at the moment, the banking system is flush with liquidity that this is a minor risk. Nonetheless, bank clients withdrawing their cash in droves would certainly hurt the reputation of the Swiss financial centre.

Retail clients make their cash-holding decisions based on interest rates for saving accounts or sight deposit. In contrast, the SNB sets short-term money market rates. While these rates usually move together, this is not always the case. After the SNB cut interest rates into negative territory in late 2014 and early 2015, commercial banks forwent negative interest rates on savings accounts and sight deposits. These rates remained positive but close to 0%, so at the moment most bank customers do not face negative interest rates even though the SNB cut three-month money market rates to –0.75%. At the same time, bank loans did not get any cheaper despite the drop in refinancing costs. This is the flipside of the coin.

With rates on savings accounts near 0%, there is still some leeway for the SNB to take rates lower. However, the leeway is limited. If the spread between money market rates and savings rates becomes too large, commercial banks will start to pass on the pain to retail clients by bringing interest rates on savings accounts into negative territory as well.

When the SNB hits the lower bound

The SNB has different options once it reaches the limits of its current monetary toolbox. What these options look like depends on the characteristics of the downturn. Downturns normally stem from abroad and are propagated to the Swiss economy by weaker external demand and a stronger Swiss franc. In rare cases do downturns originate in Switzerland, triggered from a housing market crisis for example.

In the latter case, the SNB could adopt the unorthodox monetary policy used by many Western central banks in the last 10 years. The SNB could purchase Swiss government bonds to lower the Swiss interest rate level even more, or it could purchase bank or real estate developers' bonds in case a housing market bust would endanger the Swiss financial system. While the SNB has enough monetary ammunition in such a case, it is very unlikely that the next downturn will be predominantly of domestic origin.

This means that even if there are some options left in a domestic downturn, the SNB would need to "revive" its interest rate toolkit. To do so, it could try to create an environment where it could cut nominal interest rates even further or where it could try to raise inflation expectations in order to bring real rates down.

Getting rid of physical cash

A necessary step to cut interest rates further would be to abolish (physical) cash, which offers investors an interest rate of 0%. It is the task of the central bank to provide the public with a means of payment. The SNB has to offer some sort of cash, but it could start to replace physical cash with electronic cash. From the point of view of the SNB, electronic currency has the advantage that interest rates could easily be cut into negative territory. Supporting the idea of replacing physical with electronic cash even more is that (physical) cash is losing importance in daily transactions in many economies.

Electronic cash comes with some disadvantages, however. One is that electronic cash could introduce higher volatility into the financial system. As switching from bank deposits to (electronic) cash becomes easier, this could result in large and rapid shifts between bank deposits and electronic cash – depending on the business cycle – which could destabilize the financial system.

A second drawback is that electronic cash has different characteristics than physical cash when it comes to privacy and centralisation. While physical cash transactions are peer-to-peer based and hard to trace, privacy is significantly lower in an electronic and centralised system controlled by a central bank. However, this problem could be solved by using a distributed ledger as a platform – similar as today's cryptocurrencies do. While the central bank would remain a major player, this version of cash could preserve the peer-to-peer characteristic of physical cash. But given the low scalability of today's major cryptocurrencies, the performance of such platforms would have to improve significantly in order to handle all the necessary transactions.

Adjusting the price stability goal

As an alternative to cutting nominal rates further, the SNB could try to lift inflation expectations. In the long run, inflation expectations are closely related to a central bank's inflation goal, especially in the case of a central bank with a high degree of credibility like the SNB. Lifting inflation expectations thus implies adjusting the SNB's price stability goal.

The SNB defines price stability as a rise in the national consumer price index of less than 2% per year, which implies an inflation target band between 0% and 2%. The SNB prefers to talk of a price stability goal rather than of an inflation target, as the formulation better reflects the SNB's medium to long-term goal. The definition in Switzerland thus differs from the ECB's definition of price stability, of maintaining "inflation rates below, but close to, 2% over the medium term." In the US, the Federal Open Market Committee "…judges that inflation at the rate of 2 percent […] is most consistent over the longer run with the Federal Reserve's mandate for price stability and maximum employment…".

Price stability is defined as an above 0% inflation rate by central banks because of two reasons. First, consumer price indices overestimate inflation, as they neglect or only slowly incorporate consumers' substitution alternatives. Second, economic adjustment mechanisms work less efficiently when consumer prices are falling, e.g. because of the downside rigidities in the wage-setting mechanism. That is why a slightly positive inflation target gives central banks the necessary "cushion" to operate.

Inflation at the lower end of the current target range

While the SNB has a strong record in preventing inflation from rising more than 2%, it is more accepting of low (but positive) inflation rates than other central banks. One rational for this could be the flexibility of the Swiss wage-setting process, which also works in a slightly deflationary environment (as proven in the last years). The second is Switzerland's characteristic as a small open economy. This makes it harder for the SNB to control inflation than for central banks in bigger and more closed economies such as the US and the eurozone. This explains why the SNB adopted a target range rather than a target point.

Looking at empirical evidence over the last 20 years (see Chart 2), the SNB has been able to accomplish price stability. In nearly 70% of all months (or nearly 85% when using a trimmed mean inflation measure), monthly inflation prints were in the 0 – 2% range. However, inflation was strongly biased toward the lower bound, as the median inflation rate over this time horizon was just 0.5% (0.7% for the trimmed mean inflation); 72% of all inflation prints were lower than 1% and 51% were lower than 0.5%. From its regular meetings with Swiss company managers, the SNB concludes that medium-term inflation expectations are about 1%. However, just looking at past inflation rates would point to inflation expectations in the range of 0–1%.

Chart 2: Consumer price inflation in Switzerland since 1998

Source: Macrobond, UBS

One possible way to increase inflation expectations and therefore lower the need for additional rate cuts would be to adjust the SNB's inflation goal. The SNB could narrow the range to 1–2% or could shift the range up from 0–2% to 1–3%, which would be an even stronger statement. One might argue that in a situation where the SNB barely has the instruments at hand to reach the current inflation goal, it does not make sense to set a higher target band. However, a higher inflation goal could be perceived as a very strong commitment for a monetary policy that remains highly expansive even in the very long term and thereby could change inflation expectations in a significant way.

Finally, for the SNB, it will not be about choosing one policy alternative over another, but about applying all instruments in concert to revive monetary policy in an environment of very low interest rates.

About the author

Daniel Kalt
Chief Economist Switzerland, UBS
Zürich, Switzerland

T: +41 44 234 25 60

Daniel Kalt received a PhD in economics from the University of Berne in 2000. Prior to that, he completed the Program for Beginning Doctoral Students, macroeconomics, at the Study Center Gerzensee of the Swiss National Bank in 1997 and received his master's in economics from the University of Zurich in 1996. He joined UBS in 1997 and worked as an economist in Swiss economic research while doing his PhD at the University of Berne.

In 2000, Daniel was appointed Head of Strategy Development at UBS Credit Portfolio Management. In 2003 he became Head of Swiss Economic Research and in 2011 Daniel was appointed Chief Economist Switzerland. In this position he is responsible for all research products targeted at UBS Switzerland's wealth management and corporate clients, is a regular speaker at UBS client events and advises UBS's management in Switzerland on economic and political developments. Since 2012 he also holds the Regional Chief Investment Officer Switzerland position.

About the author

Alessandro Bee
Swiss Economic Research, UBS
Zürich, Switzerland

T: +41 44 234 88 71

Alessandro Bee joined the Swiss Economic Research department of UBS at the beginning of 2016. Within Swiss Economic Research he is responsible for the business cycle analyses of the Swiss economy. Before joining UBS, Alessandro worked for 10 years in the financial industry as a global economist, a fixed income strategist and a forex analyst. He also worked as an economics teacher before joining the financial industry. Alessandro holds a PhD from the University of Basel in the field of macroeconomics and econometrics. He received a master’s in business and economics from the University of Basel and completed the Program for Beginning Doctoral Students at the Study Center Gerzensee of the Swiss National Bank.