Jean-Pierre Roth: Recent economic and financial developments in Switzerland
Introductory remarks by Mr Jean-Pierre Roth, Chairman of the Governing Board of the Swiss National
Bank and Chairman of the Board of Directors of the Bank for International Settlements, at the
half-yearly media news conference, Berne, 14 June 2007.
* * *
The Swiss National Bank is raising the target range for the three-month Libor with immediate effect by
0.25 percentage points to 2.00-3.00%. With this move, the National Bank is ensuring that inflation
prospects remain favourable. The SNB intends to hold the rate in the middle of the target range for the
time being.
Switzerland's economy is in excellent shape. Indeed, the economy is developing even better than
expected back in March. For 2007, the National Bank now expects real GDP to grow at a rate of close
to 2.5%. The healthy economy in the neighbouring countries and exchange rate developments have
been contributing factors. Together with a renewed rise in oil prices, this has led to a slight
deterioration in inflation prospects - even after today's increase in the interest rate. Assuming that the
three-month Libor remains unchanged at 2.50%, the National Bank expects an average annual
inflation rate of 0.8% in 2007, 1.5% in 2008, and 1.7% in 2009. Consequently, forecast inflation
continues to rise.
However, at present there is considerable uncertainty with regard to the assessment of the inflation
outlook. On the one hand, structural changes in the economy still have a dampening effect on prices.
On the other hand, given the high level of capacity utilisation and movements in the exchange rate,
there is a danger that higher production costs will increasingly be passed on to prices. Should
economic momentum remain unchanged or should movements in the Swiss franc result in a further
relaxation of monetary conditions, further increases in the interest rate are likely in the months ahead.
Economic outlook
The international environment has a strong impact on economic developments in Switzerland.
According to the IMF forecasts, the global economy is poised to grow at a sustained rate of
approximately 5% in 2007. While the economic activity in the United States has been satisfactory, it is
a little less dynamic than expected. By contrast, the economic situation in Europe is clearly healthier
than we had expected. This encouraging development has had a favourable impact on our economy.
Economic activity in Switzerland continued to be dynamic in the first months of the year. In the first
quarter, gross domestic product (GDP) was up by 3.2% saar, exceeding the long-term average growth
rate by a significant amount.
The strong economic performance assisted the recovery of the labour market. Employment was up in
industry as well as in the construction and service areas. As a result, unemployment figures dropped
further and the unemployment rate fell below the level of 3%. Demand indicators were still trending
upwards, which should result in a renewed drop in unemployment in the months ahead. Moreover,
labour demand continued to be met by a significant influx of labour from abroad. The opening of the
labour market within the context of the bilateral agreements with the EU creates additional growth
potential.
The competitive position of our economy is high, and the recent depreciation of the Swiss franc on the
foreign exchange market gave it an additional boost. While exports continued to increase at a rapid
pace, their growth rate may slow down somewhat compared with 2006.
The healthy state of the economy and the improvement in the labour market have a favourable impact
on consumer sentiment. Since the beginning of the year, household spending has been increasing at
very steady pace. A continuance of this trend is possible, since the current near full employment is
likely to lead to an increase in real wages.
During the next quarters, companies will continue to step up equipment investment since the rate of
technical capacity utilisation - in particular in the manufacturing sector - is high. Construction
investment should stabilise at a high level.
These developments in demand components led us to revise our GDP growth forecast upwards for
2007. For the current year, we now expect growth close to 2.5%.
Development in monetary and financial conditions
In the Swiss capital market, we have been observing a steady increase in long-term interest rates over
the past three months. The yield on 10-year Swiss Confederation bonds reached 3% in May. Real
interest rates for long maturities have therefore registered an increase. This is a new development
because up until now, long-term interest rates had not clearly reacted to the progressive increase in
the Libor. This will reinforce our efforts to tighten monetary conditions, since economic activity reacts
more noticeably to long-term interest rates than to short-term ones.
By contrast, in foreign exchange markets, movements in the Swiss franc have resulted in a relaxation
of monetary conditions. As of the beginning of 2006, the Swiss franc started losing ground steadily
visà-vis the euro. However, it firmed slightly against the dollar during the same period. Since our March
assessment, the actual depreciation of the Swiss franc, i.e. weighted in terms of exports , amounts to
1.7%. The corresponding relaxation in monetary conditions is weakening the effects of our policy of
lifting interest rates and is increasing inflationary pressure through two channels. One the one hand, it
is bringing about an increase in import prices, which could have an effect on consumer prices. Even
though the impact of this channel may have diminished during the past few years due to increased
competition, there is no guarantee that - against the current backdrop of near full employment - it will
not again be reactivated. On the other hand, it is strengthening the competitive position of our
economy, thereby giving exports and economic activity a boost. As a consequence, the weak franc
could heighten inflationary pressure in an economy already running at full steam.
On the credit market, growth in mortgage lending is slowly receding, with the current rate of increase
below 5%. The "other loans" category continues to expand rapidly, while matching observations of the
past in comparable phases of the economic cycle. This category is now growing at a rate of about 8-
10%, as at the beginning of the 2000s, when their level in fact considerably exceeded the levels we
are currently experiencing.
M1 and M2 shrank, which is nothing out of the ordinary during a phase of rising interest rates. When
this happens, savings and sight deposits are shifted into time deposits. M1 and M2 are affected by this
substitution. M3, which is not affected, is growing at a rate of 2% to 3%, which is appropriate for an
expanding economy.
Inflationary risks
In the current environment, price stability is subject to three types of risk:
The first risk is connected with the development in the price of oil. The barrel price for Brent crude rose
by 40%, from USD 51.0 in January to USD 71.7 in May. This will lead to higher inflation during the
course of the year. Unlike oil price hikes between 2004 and 2006, the most recent rally took place
when capacity utilisation was higher. If the current surge in oil prices were to continue, it could affect
prices more easily than previously.
The second risk is due to the fact that demand is growing at too rapid a pace in relation to the
development in production capacity. We estimate the GDP growth rate that can be sustained without
pushing up inflation - potential GDP growth - at between 1.5% and 2%. This is lower than the growth
rate we have observed since 2006. Measuring the output gap is tricky, however, because certain
favourable factors, such as the influx of skilled labour, the deregulation of certain domestic markets
and increased global competition might have pushed up potential GDP growth. Having said this,
however, we should not overlook those factors which have the opposite effect. For instance,
equipment investment has receded, which has a dampening effect on potential growth. Moreover,
even if capacity utilisation as a whole is not excessive, bottlenecks might occur in certain sectors of
the economy. And, above all, experience has shown that the output gap is often underestimated
during phases of growth. Consequently, the risk of underestimating the output gap may now be
greater than that of overestimating it.
The third risk is associated with the future development of the Swiss franc. As its exchange rate is
determined by the market, it is subject to fluctuations. Movements in the export-weighted Swiss franc
index alter the degree of restrictiveness of our monetary policy. Normally, during periods of rising
interest rates, this index tends to increase, thereby amplifying the effects of monetary policy by
mitigating price increases in imported products and slowing the expansion in economic activity. This
reaction pattern was not observed during the past two years, which could put pressure on interest
rates.
Monetary policy decision
Before commenting our decision today, I would like to point out the changes that are shaping our
current environment. In December 2005, when the present cycle of interest rate hikes began, we were
concerned with the normalisation of the interest rate level - at the time the Libor was at 0.75% - while
allowing the economy to reduce its level of unused resources. Our concern now is to ensure that
monetary conditions are such that the healthy state of the economy does not jeopardise price stability
in the medium term.
We are still observing that the competitive pressure in the market is high, the labour market very
flexible and that movement in the monetary aggregates is moderate. However, my analysis of the
current situation has demonstrated that the inflation outlook has deteriorated in different respects since
our last assessment: higher oil prices will have an impact on the consumer price index; economic
performance, which is better than expected, will result in an improved utilisation rate and increase
pressure on prices and, finally, a renewed weakening of the Swiss franc has neutralised the intended
tightening in monetary conditions. Today's decision to raise the target range for the three-month Libor
by 25 basis points takes into account this deterioration in the outlook for price stability.
Inflation forecast graph
I will now turn to the last part of my remarks. What is our inflation forecast? The dashed red curve
represents the new forecast which covers the period from the second quarter of 2007 to the first
quarter 2010. It shows the inflation outlook after today's increase in the Libor under the assumption
that the level of 2.50% will be kept constant during the forecasting period. For purposes of
comparison, the dash-dotted green curve shows the inflation forecast of the March monetary
assessment which was based on a Libor of 2.25%.
The combined effect of higher oil prices, economic developments that were better than expected and a
weaker franc leads to a deterioration in the inflation forecast for the coming months. Today's interest
rate rise will stabilise the rate of inflation at a slightly higher level from mid-2008 onwards than that
established last March. Inflation will subsequently continue to rise and approach the 2% mark towards
the end of the forecasting period.
* * *
In lifting the three-month Libor by 25 basis points today, deterioration in the inflation prospects over the
past months will be offset. Any forecast and any decision are obviously fraught with uncertainty and
risk. Should economic momentum remain unchanged or should movements in the Swiss franc result in
a further relaxation in monetary conditions, further increases in the interest rate are likely in the
months ahead.
BIS Review 67/2007