Did Bennett McCallum run the SNB for the last 20 years?

Which central bank has conducted monetary policy in the best way in the last five years? Among “major” central banks the answer in my view clearly would have to be the SNB – the Swiss central bank.

Any Market Monetarist would of course tell you that you should judge a central bank’s performance on it’s ability to deliver nominal stability – for example hitting an nominal GDP level target. However, for an small very open economy like the Swiss it might make sense to look at Nominal Gross Domestic Demand (NGDD).

This is Swiss NGDD over the past 20 years.

NGDD Switzerland

Notice here how fast the NGDD gap (the difference between the actual NGDD level and the trend) closed after the 2008 shock. Already in 2010 NGDD was brought back to the 1993-trend and has since then NGDD has been kept more or less on the 1993-trend path.

Officially the SNB is not targeting NGDD, but rather “price stability” defined as keeping inflation between 0 and 2%. This has been the official policy since 2000, but at least judging from the actually development the policy might as well have been a policy to keep NGDD on a 2-3% growth path. 

Bennett McCallum style monetary policy is the key to success

So why have the SNB been so successful?

My answer is that the SNB – knowingly or unknowingly – has followed Bennett McCallum’s advice on how central banks in small open economies should conduct monetary policy. Bennett has particularly done research that is relevant to understand how the SNB has been conducting monetary policy over the past 20 years.

First, of all Bennett is a pioneer of NGDP targeting and he was recommending NGDP targeting well-before anybody ever heard of Scott Summer or Market Monetarism.  A difference between Market Monetarists and Bennett’s position is that Market Monetarists generally recommend level targeting, while Bennett (generally) has been recommending growth targeting.

Second, Bennett has always forcefully argued that monetary policy is effective in terms of determining NGDP (or NGDD) also when interest rates are at zero and he has done a lot of work on optimal monetary policy rules at the Zero Lower Bound (See for example here). One obvious policy is quantitative easing. This is what Bennett stressed in his early work on NGDP growth targeting.  Hence, the so-called Mccallum rule is defined in terms the central bank controlling the money base to hit a given NGDP growth target. However, for small open economies Bennett has also done very interesting work on the use of the exchange rate as a monetary policy tool when interest rates are close to zero.

I earlier discussed what Bennett has called a MC rule. According to the MC rule the central bank will basically use interest rates as the key monetary policy rule. However, as the policy interest rate gets close to zero the central bank will start giving guidance on the exchange rate to change monetary conditions. In his models Bennett express the policy instrument (“Monetary Conditions”) as a combination of a weighted average of the nominal exchange rate and a monetary policy interest rate.

SNB’s McCallum rule

My position is that basically we can discribe SNB’s monetary policy over the past 20 years based on these two key McCallum insights – NGDP targeting and the use of a combination of interest rates and the exchange rate as the policy instrument.

To illustrate that I have estimated a simple OLS regression model for Swiss interest rates.

It turns out that it is very to easy to model SNB’s reaction function for the last 20 years. Hence, I can explain 85% of the variation in the Swiss 3-month LIBOR rate since 1996 with only two variables – the nominal effective exchange rate (NEER) and the NGDD gap (the difference between the actual level of Nominal Gross Domestic Demand and the trend level of NGDD). Both variables are expressed in natural logarithms (ln).

The graph below shows the actually 3-month LIBOR rate and the estimated rate.

SNB policy rule

As the graph shows the fit is quite good and account well for the ups and down in Swiss interest rates since 1996 (the model also works fairly well for an even longer period). It should be noted that I have done the model for purely illustrative purposes and I have not tested for causality or the stability of the coefficients in the model. However, overall I think the fit is so good that this is a pretty good account of actual Swiss monetary policy in the last 15-20 years.

I think it is especially notable that once interest rates basically hit zero in early 2010 the SNB initially started to intervene in the currency markets to keep the Swiss franc from strengthening and later – in September 2011 – the SNB moved to put a floor under EUR/CHF at 120 so to completely curb the strengthening of Swiss franc beyond that level. As a result the nominal exchange rate effectively has been flat since September 2011 (after an initial 10% devaluation) despite massive inflows to Switzerland in connection with the euro crisis and rate of expansion in the Swiss money supply has accelerated significantly.

Concluding, Swiss monetary policy has very much been conducted in the spirit of Bennett McCallum – the SNB has effectively targeted (the level of) Nominal Gross Domestic Demand and SNB has effectively used the exchange rate instrument to ease monetary conditions with interest rates at the Zero Lower Bound.

The result is that the Swiss economy only had a very short period of crisis in 2008-9 and the economy has recovered nicely since then. Unfortunately none of the other major central banks of the world have followed the advice from Bennett McCallum and as a result we are still stuck in crisis in both Europe and the US.

PS I am well-aware that the discuss above is a as-if discussion that this is what the SNB has actually said it was doing, but rather that it might as well been officially have had a McCallum set-up.  

PPS If one really wants to do proper econometric research on Swiss monetary policy I think one should run a VAR model on the 3-month LIBOR rate, the NGDD gap and NEER and all of the variables de-trended with a HP-filter. I will leave that to somebody with econometric skills and time than myself. But I doubt it would change much with the conclusions.

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