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 thinks it was a terrible decision – but because I so far has 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 dissatisfies with how it’s 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 have no problems 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 – lets implement a massive tightening of monetary conditions and see what will happens”. And what happened? Everybody in the SNB management screamed “Great idea! Lets 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 to 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 Swiss franc. That said over the past year or so I have become increasingly sceptical 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 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 policy instrument 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 announced 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 it in the future would use the ‘mid-point’ of the fluctuation band as the de facto ‘instrument’ for implementing monetary policy so to signal that the mid-point could be changed always to hit the ultimate monetary policy target – for example 2% (expected) inflation.

That would mean that if inflation expectations were below 2% then the Swiss franc would tend to depreciate within the fluctuation band as the market (rightly) would expect the SNB to move the mid-point of the band to ensure that it would hit the inflation target.

This would also mean that there would be a perfect ‘ordering’ of targets and instruments. The expectations for inflation relative to the inflation target would both determine the expectations for the development in the exchange and what intermediate target SNB would set for EUR/CHF. This would mean that under normal circumstances where SNB’s regime is credible the market would effectively implement SNB policy through movements in the exchange rate within the fluctuation band.

As a consequence the SNB would rarely have to do anything with the money base. Of course one can of course think of periods where the SNB’s credibility is tested – for example if a spike global risk aversion causes massive inflows into CHF and push the CHF stronger even if inflation expectations are below the inflation target. That said the SNB would never have to give up “defending” CHF against strengthening as the SNB after all has the ability to print all the money it needs to defend the peg.

Of course this is the ability that has been tested recently, but I believe that the appreciation pressure on CHF has been greatly increased by the SNB failure to move up the target in response to the clear undershooting of he inflation target. Hence, the reluctance to respond to deflationary pressures really has undermined the peg.

Had the SNB moved up the EUR/CHF peg to 130 or 140 six months ago then there would not have been the appreciation pressures on the CHF we have seen and the SNB would not have had to expand its balance sheet as much as have been the case.

The ‘regime’ I have outlined above is any many ways similar to Singapore’s monetary regime where the monetary authorities use the exchange rate rather than interest rates to implement monetary policy. In such a regime the central bank allows interest rates to be completely market determined and the central bank would have no policy interest rate.

This would have that clear advantage that there would never be any doubt what target the SNB would be trying to hit and how to hit it. This of course is contrary to the ‘old’ regime where the SNB effectively tried to have both an exchange rate target, an interest rate target and the inflation target. This inherent internal contradiction in the system I believe is the fundamental reason why SNB’s management felt it had to give it up.

Unfortunately the SNB so far has failed to put something else instead of the old regime and we now seem to be in a state of complete monetary policy discretion.

I hope that the SNB soon will realise that monetary policy should be rule-based and transparent. My suggestion above would be such a regime.

Update: I realise that I really should have dedicated this blog post to Irving Fischer, Lars E. O. Svensson, Bennett McCallum, Robert Hetzel and Michael Belongia. Their work on monetary and exchange policy greatly influenced the thinking in the post.


When central banks ignore the Tinbergen rule – the case of RBNZ

The news from the global currency markets this morning:

New Zealand’s dollar was set for its biggest three-day drop since 2011 after the Reserve Bank said its sales of the currency in August were the most in seven years. The greenback headed for its best month since 2012

The kiwi dropped against all 31 major counterparts as Prime Minister John Key was reported as signaling that the currency needs to be weaker. Australia’s dollar declined below 87 U.S. cents for the first time since January. The Hong Kong dollar weakened along with equities in the Asian city amid the largest police crackdown on protesters since it returned to Chinese rule. The euro fell to its lowest in 22 months versus the greenback before the European Central Bank meets Oct. 2.

Everything is wrong about this. I normally think that the Reserve Bank of New Zealand (RBNZ) is doing a fairly good job, but over the past couple of years it has become increasingly erratic in its behaviour and seems to be having a problem focusing on its stated objective of keeping inflation close to its inflation target.

Hence, the RBNZ has in recent years had a pre-occopation with the development in the New Zealand property market and household debt etc. and now it is the level of the kiwi dollar, which is on the mind of the RBNZ. And maybe worse the Prime Minister is now also thinking that he should get involved in monetary policy decision making – at least indirectly.

You gotta ask yourself what monetary policy goal the RBNZ have? After all you cannot have the cake and it eat too. That is the Tinbergen rule – you can only have one policy objective for each policy instrument.

The intervention in the currency market seems particularly odd when we remember that the RBNZ is not unlike a lot of other central banks stuck at the Zero Lower Bound – RBNZ’s policy rate the Overnight Cash Rate is 3.5%. Said, in another way if the RBNZ thinks that the strengthening of the kiwi dollar in anyway was threatening its key policy objective (1-3% inflation) then it can just got the key policy rate.

Furthermore, the New Zealand economy does not exactly look like it needs monetary easing – real GDP growth is outpacing potential growth, inflation is within the inflation target range and inflation expectations seem to be quite close to the 2% mid-point of the inflation target range. And any Market Monetarist would of course also notice that nominal GDP growth has been extreme buoyant over the past year (admittedly it is slowing now).


The strong growth in nominal GDP during 2013 to a large extent reflected a sharp rise in New Zealand’s export prices particular higher dairy prices. That trend has changed significantly in 2014 and that has actually put considerable depreciation pressure on the kiwi dollar recently, but apparently there is enough pressure on the kiwi dollar if you listen to Prime Minister John Key and the RBNZ.

Just ask yourself the question what if the kiwi dollar remains “too strong” for the liking of the RBNZ and the Prime Minister and the RBNZ decides to intervene more what would then happen? What is currency intervention? It is money creation. The RBNZ would print kiwi dollar – expanding the money base.

That eventually will spur NGDP growth and with the economy operating at more or less full capacity utilisation this will spur inflation and increase inflation expectations above the RBNZ’s inflation target. So the question is how much higher inflation will the RBNZ be willing to accept to weaken the kiwi dollar? Will it be willing to jeopardize its inflation target?

This demonstrates that the RBNZ only permanently can weaken the kiwi dollar if it is compatible with the RBNZ’s inflation target. Unless of course the New Zealand government is willing to introduce capital and currency controls. That luckily that does not seem to be on the agenda.

If the RBNZ is targeting inflation then the RBNZ will have to accept the level for the kiwi dollar, which is determined by market forces. If it on the other hand wants to target the exchange rate then it fundamentally will have to give up its inflation target.

I don’t think that the RBNZ is going to mess up things dramatically, but the RBNZ’s pre-occopation with the level of the kiwi dollar is yet another example that central bankers around the world still fundamentally have a hard time accepting the logic of the Tinbergen rule. But there is no way around it – you can only have one monetary policy target – the inflation rate, the price level, the NGDP level or the exchange rate. You can’t do it all.

PS I have often argued that central banks in small open economies use the exchange rate as an way implement monetary policy if it is stuck at the Zero Lower Bound and if monetary easing is needed. However, that is not the case for the RBNZ.

PPS Maybe I am wrong and it might just be the case that the RBNZ knows better than the market – just see here (I don’t really think I am wrong…)

PPPS The RBNZ does not exactly have a good experience playing around with quasi-exchange rate targeting. See here.

Reserve Bank of India and the Tinbergen rule: Please end the stop-go policies!

It is hard to keep track of the direction of monetary policy in India. This is from Bloomberg this morning:

Indian (SENSEX) stocks climbed for the first time in four days, led by the biggest rally in financial shares since 2009, after the central bank said it will buy government bonds to combat surging borrowing costs.

So now the Reserve Bank of India (RBI) is effectively doing quantitative easing. Meanwhile this is also from Bloomberg not long ago:

The Reserve Bank of India on July 22 made it mandatory for importers to set aside 20 percent for re-exports as jewelry. The measures to moderate demand boosted the premium that jewelers pay to importers to about $10 an ounce over the London spot price from as low as $4 a week earlier, according to the the All India Gems & Jewelry Trade Federation.

Hence, RBI stepped in to curb the buying of gold by Indians to stop the sell-off in the rupee. That of course was monetary tightening.

The truth is that RBI is trying to do everything at the same time—ease monetary policy to push down yields, tighten monetary policy to curb the sell-off in the rupee, while at the same time trying to curb inflation by tightening monetary policy and easing monetary policy to spur growth. Confused? Not as much as the RBI…

It is about time that somebody reminds the RBI about the Tinbergen Rule: For each and every policy target there must be at least one policy tool. If there are fewer tools than targets, then some policy goals will not be achieved.

The only thing RBI fundamentally can do is to control the money base to hit one nominal target. Therefore, it is also about time that RBI comes clean on this.

RBI can only hit one target (with one instrument). That target in my view should be a nominal gross domestic product (GDP) target, but the most important thing now is that RBI just announces one nominal target—be it an inflation target, a price level target or a nominal GDP target.

RBI should immediately end the attempts to distort financial prices—whether in the fixed income or the currency market. Leave it to the markets to determine the prices in the fixed income markets and the currency markets.

If RBI is concerned about the heightened volatility in the Indian financial markets it should at least stop creating volatility on its own. The best way of doing this of course is to announce a clear rule-based monetary policy.

There is only so much monetary policy can do. Monetary policy is extremely effective when it comes to hitting a nominal target, but monetary policy cannot do much about India’s other problems—for example the major public finance problems. The Indian government has to take care of that problem.

PS One can of course fear that RBI will not give up on trying to hit more than one target. Then it, however, will need more policy instruments. Normally this would be capital and currency controls. God forbid the RBI will venture down that road.

This post has also been publlished at livemint.com.

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