Fritz Zurbrügg: Monetary policy and financial markets - is a return to
normal on the horizon?
Speech by Mr Fritz Zurbrügg, Member of the Governing Board of the Swiss National Bank, at
the Money Market Event, Geneva, 21 November 2013.
* * *
The speaker would like to thank Bettina Simioni for her valuable support in preparing this speech. I am also
indebted to Marco Huwiler, Rita Kobel and Peter Kuster for their insightful comments.
Ladies and gentlemen
Welcome to the Money Market Event of the Swiss National Bank (SNB) in Geneva. It is a
great pleasure for me to be able to address you here today for the second time. I am
particularly delighted because I am able to talk to you today with a good deal more
confidence than I could a year ago. The situation on the European financial markets has
calmed perceptibly, and it is more than a year since the SNB has had to intervene in the
foreign exchange market to defend the minimum exchange rate of CHF 1.20 against the
euro.
But let us turn the clock back to 2012 for a moment. At that time, a great many market
participants feared that the euro area would collapse. The upward pressure on the Swiss
franc was immense. As a result, our willingness to defend the minimum exchange rate with
all our resources was put to a severe test. In 2012, we purchased foreign currency for a
value of almost CHF 190 billion. Consequently, my statements last year were devoted to the
growth in foreign currency reserves and the associated challenges.
Today I would like to discuss the question of whether a return to normal is on the horizon
either for monetary policy - initially in the US - or for financial markets. Although various
signs on the financial markets point in this direction - including the calming of the bond
markets in Europe's peripheral economies, record highs on stock markets and the rise in
long-term interest rates since mid-year - other observations are less encouraging. Global
economic recovery is merely sluggish and the risks for growth are still to the downside.
Unemployment, particularly in the euro area, is very high and many structural reforms have
been postponed. Against this background, financial markets are not expecting any of the
major central banks to raise their reference rates before 2015.
In answering the question above, I will begin by talking about developments in financial
markets, with a special focus on the Swiss franc. Then I will discuss monetary policy at the
US Federal Reserve and its first attempt to bring about a restoration of normal conditions.
Afterwards, I will give a brief presentation of the economic situation with a focus on Europe.
In conclusion, I would like to draw your attention to the dangers associated with a prolonged
period of low interest rates.
European financial markets calmer thanks to monetary policy
If you take a look at chart 1, you can follow the movements in both the euro/Swiss franc
exchange rate and the average risk premium for the government bonds of five peripheral
euro area countries (Italy, Spain, Greece, Portugal and Ireland). The risk premium is drawn
on an inverted scale, in other words, a movement downwards signifies a higher risk. This
chart serves as an illustrative example for two developments. On the one hand, it shows that
uncertainty in the euro area has decreased greatly over the past twelve months. At the time
of the last Money Market Event in Geneva, the risk premium was almost 1,200 basis points;
it is now below 400. On the other hand, the chart illustrates the fact that the upward pressure
on the Swiss franc has abated. Following a long period last year when the exchange rate
stuck closely to the minimum exchange rate of CHF 1.20, it moved away in January and,
since May, has fluctuated within a relatively narrow range of CHF 1.22-1.26 per euro.
Here, the situation has calmed in two respects. In order to reduce the risk of the euro area
collapsing, the European Central Bank (ECB) resorted to an unconventional measure in late
summer 2012, the outright monetary transactions programme. Market participants were
persuaded, and since then the risk premium for peripheral economies in Europe has declined
steadily. What is remarkable is how persistent this trend has been. The positive market
sentiment on the European markets has defied both negative reports from the real economy
and various political crises, even those in major member states such as Italy. The lower
interest rates have improved the growth outlook in the euro area and opened up a time
window for structural reform.
A certain degree of calming also occurred for the Swiss franc exchange rate. Demand
declined for investments which were seen as safe havens, such as the Swiss franc, with the
result that foreign currency purchases to defend the minimum exchange rate have not been
necessary for over a year. However, investors remain cautious, as can be seen in chart 1.
First, the exchange rate did not perceptibly move away from the CHF 1.20 level until January
2013, in other words, after many months of declining risk premia. Second, the Swiss franc
has not weakened fundamentally against the euro during the course of this year, although
risk premia have declined further. Nevertheless, many market participants expect a renewed
depreciation in the Swiss franc in view of the progress in the euro area. The value of the
Swiss franc is still high at present. As can be seen in chart 2, the trade-weighted,
inflationadjusted exchange rate for the Swiss franc, for instance, is currently about 10% above its
long-term average. The minimum exchange rate continues to prevent an undesired
tightening of monetary conditions should the upward pressure on the Swiss franc intensify
once again in view of the current uncertainty.
Exceptional circumstances still apply for monetary policy
Clearly, exceptional circumstances still apply for monetary policy. This is the case not only
for Switzerland and the euro area, but also for the US, Japan and the UK. As you know, the
ECB reduced its refinancing rate by a further 25 basis points two weeks ago. In the US and
Japan, current quantitative easing measures are giving rise to a further expansion in central
bank balance sheets. The fact that monetary policy in the advanced economies is likely to
remain exceptionally expansionary for some time to come can be seen in market
expectations for reference rates (cf. chart 3). At the moment, the markets are assuming that
the Federal Reserve will increase its key interest rate in the second quarter of 2015, the ECB
in the fourth quarter of 2015 and the SNB in the first quarter of 2016.
Last year, a number of central banks introduced the principle of forward guidance, in order to
further increase the effectiveness of their expansionary monetary policy. Forward guidance
involves the provision of information on the expected movement of short-term interest rates.
To some extent, information of this kind has already been provided by central banks in the
past. What is new with forward guidance is that some central banks give an explicit indication
of how long they expect low interest rates to continue. For instance, the Federal Reserve and
the Bank of England have tied the assessment of their respective reference rates to a
threshold for the unemployment rate. At the moment, an intense debate is raging as to
whether forward guidance can actually increase the effectiveness of monetary policy in a
zero interest rate environment. What is crucial for the effectiveness of forward guidance is
that it is transparent and credible.
In the case of the SNB, the inflation forecast provides implicit information about the expected
interest rate path. At present, however, the minimum exchange rate against the euro is also
in place. With short-term interest rates close to zero, the minimum exchange rate makes it
possible, for the foreseeable future, to ensure monetary conditions that are appropriate for
the Swiss economy.
Irrespective of any kind of forward guidance, international monetary policy is extremely
expansionary. This has had a stabilising effect on international financial markets, as reflected
by the situation in spring, when long-term interest rates sank to a historically low level and
risk markets benefited from strong capital inflows. Various stock indices recorded new
historical highs and risk premia for corporate bonds have steadily narrowed. This positive
sentiment was also reflected in volatility measures which had returned to the levels prevailing
before the financial crisis.
First attempt to normalise monetary policy in the US
Together with a revival of the economy in the US, this favourable environment resulted in the
Federal Reserve making a first attempt to initiate the process of normalising monetary policy.
On 22 May 2013, the Chairman of the Federal Reserve, Ben Bernanke, first mentioned the
possibility that the ongoing third quantitative easing programme might be tapered off.
The possibility that the Federal Reserve might announce a reduction in the monthly bond
purchase programme sparked an increase in long-term US interest rates, which had risen by
over 100 basis points by the beginning of September (cf. chart 4). All other major markets
reacted in the same way - this included interest rates in Germany - despite the fact that the
course of monetary policy in the euro area actually pointed to sustained expansion. The
tapering debate coincided with a more favourable economic outlook in the advanced
economies. This, in turn, increased uncertainty with regard to the future monetary policy path
of the major central banks, and term premia - which form part of bond yields - rose.
However, at the same time, short-term interest rates stayed firmly in place. Despite the
recent increase, bond yields in advanced economies are at a very low level in historical
terms.
The impact on foreign exchange markets varied. The currencies of the emerging economies
reacted particularly strongly, with capital outflows exerting very substantial downward
pressure, as can be seen in chart 4. This shows that a number of emerging economies are
still vulnerable to foreign portfolio investments, or hot money flows. The G4 currencies, by
contrast, have been largely unaffected by the tapering debate (cf. chart 5). In trade-weighted
terms, the US dollar has gained very slightly. The euro and the pound sterling also
strengthened somewhat in the light of surprisingly favourable economic data. The Swiss
franc is almost unchanged, with neither the tapering debate nor the ECB interest rate
reduction two weeks ago triggering significant movements.
This first attempt by the Federal Reserve to normalise monetary policy has made a number
of things clear. First, the very expansionary monetary policy has made a major contribution to
the positive sentiment on financial markets. Paradoxically, stock markets are reacting to
negative macroeconomic data with gains, since markets expect that expansionary monetary
policies will be maintained as long as economic growth remains weak. If the data are good,
the opposite will occur. Second, the hefty reactions of some markets point to the danger that
an exit from the exceptionally expansionary monetary policy could prove to be bumpy.
Uncertainty about future monetary policy direction is predominant in the current market
environment, and it is therefore vulnerable to abrupt changes in expectations on the part of
investors. Tapering represents a challenge for the Federal Reserve. However, we are
working on the basis that this process can be conducted step by step, without major
disruptions.
Growth momentum in the global economy remains moderate
Looking at the global economic outlook, there is little to substantiate the possibility that a
return to normal for monetary policy has moved closer. The recovery in the economy is
delayed and the International Monetary Fund (IMF) has repeatedly reduced the 2013 growth
forecast for the global economy during the course of the year (cf. chart 6). The latest World
Economic Outlook by the IMF reports that "Global growth is in low gear (...) and downside
risks persist." The IMF now anticipates global growth of 2.9% for 2013 and 3.6% for 2014.
A change in growth momentum is becoming evident at a global level. Chart 7 shows the
purchasing managers indices (PMIs) for various countries. On the vertical axis we see the
current level of PMIs and on the horizontal axis, movements over the past six months.
Momentum in the emerging economies has declined recently (red ring). By contrast, the
advanced economies are picking up, in particular in the euro area (green ring). Moreover,
PMIs for most of these economies are above the growth threshold of 50 points. Growth in the
US, especially, is very robust and, on this side of the Atlantic, the UK has exceeded
expectations (blue ring).
Particularly important for Switzerland were the surprisingly favourable economic indicators in
Europe this summer. In the second quarter of 2013, the euro area reported positive growth
for the first time in six quarters. There are encouraging signs from the peripheral economies,
especially. Since mid-year, for instance, these countries have again been recording
surpluses on their current accounts. Nevertheless, these signs must be put into perspective.
The improvement in the peripheral economies is beginning from a very low base level and
the unemployment figures are oppressive. The banking system is very fragmented and
unhealthy bank balance sheets give rise to declining levels of lending. This hampers the
monetary policy transmission mechanism. In addition, there are sustained high levels of
public and private debt. All of these factors are likely to hold back economic developments in
the peripheral economies for some time yet. Moreover, the euro area remains extremely
heterogeneous. Chart 8 shows the level of real gross domestic product (GDP) in the euro
area and its largest members, as well as for Switzerland. In Italy and Spain, GDP is just
under 10% below the maximum pre-crisis level, while in Germany it has been above the
precrisis figure since 2011.
Given the subdued developments in the euro area, it is surprising how well the Swiss
economy has performed. In Switzerland, GDP is already almost 5% above the pre-crisis
level. However, it should be borne in mind that, over the past few years, economic growth
has been extensively supported by the increase in the population. In terms of GDP per
capita, Switzerland has not yet quite returned to the pre-crisis figure, unlike Germany, for
instance, where per-capita GDP is now almost 3% above the pre-crisis level. The growth
driver in Switzerland has thus been the domestic economy, while the contribution provided
by foreign trade has been relatively modest. There are substantial differences from one
industry to another. In general, the services industries are growing and business remains
very lively in construction. In manufacturing, by contrast, which is traditionally cyclical and
export-oriented, developments have been less advantageous, and equipment investment
has also suffered in Switzerland. The output gap remains negative, so that there is no
pressure on wages and prices in the foreseeable future. The outlook is favourable, since we
expect that the gradual recovery of the economy in Europe will stimulate demand for Swiss
exports. We anticipate growth of 1.5-2.0% for the current year.
Dangers of a prolonged low-interest period
What do these tentative global economic developments mean for monetary policy? Most
central banks maintained their very expansionary course and the various unconventional
measures. These measures were largely uncontested as long as they served to stabilise
financial markets and the banks and subsequently to stimulate the economy. However, the
longer the current low interest rate period continues, the greater the associated risks can be.
I would now like to talk about two of these risks - the increasing price distortions in various
investment categories and the decreasing motivation to undertake structural reform
measures.
Increasing price distortions: The very low interest rates affect aggregate demand in the
economy both directly and also via the wealth effect. One of the effects which expansionary
monetary policy abroad encourages is the quest for yield and, with it, the transfer of assets
into more risky investments. However, low interest rates can result in misallocation on
financial markets, particularly when they persist for a long period of time. It is possible that
risks may be misjudged and, as a result, relative prices distorted. It is naturally difficult to
establish the point at which price movements of this kind need to be considered as excesses.
In the past, long periods of rising prices were always followed by corrections. The hefty
reaction of risk markets to the tapering debate can be read as a sign of the instability of
certain asset prices.
In Switzerland, for instance, the low interest rates have stimulated activity in the mortgage
and real estate markets, where, for a number of years now, we have seen considerable
momentum which can only be partially explained by movements in fundamental factors. As a
result, imbalances have built up. For example, mortgage volumes have grown significantly
faster than GDP for many years, as can be seen in chart 9. The SNB has issued repeated
warnings about the risks for financial stability associated with these developments. This is
the background to the Federal Council's activation of the countercyclical capital buffer (CCB)
at the beginning of this year, upon the proposal of the SNB. The CCB has been in force since
the end of September and its primary aim is to increase the resilience of the banking system
against these risks and to combat excessive credit growth. Since low interest rates can be
expected to persist in Switzerland for some time yet, we are keeping a very close watch on
developments in the mortgage and real estate markets.
Lower interest rates mean more favourable
Waning motivation for reform measures:
refinancing costs for banks, companies and governments. Expansionary monetary policy
following a financial crisis and recession can therefore open up a welcome time window for
carrying out consolidation measures, cleaning up bank balance sheets and implementing
structural reform measures. However, if decision-makers have reason to believe that low
interest rates will probably remain in place for a long time yet, their motivation to undertake
reform measures is likely to flag. This is particularly the case in countries where reforms have
been under way for many years now, but are still insufficient, and where resistance at the
political level is now on the increase. Here the temptation to depend on low interest rates - or
even to increase political pressure on the central bank to keep interest rates low for longer
than necessary - is especially pronounced.
In this context, it is important not to forget that central banks cannot do everything. They
cannot restructure public sector budgets and they cannot carry out structural reforms. Nor
can they provide substitutes for sensible fiscal policies. This area is the responsibility of other
economic agents. A prosperous economy requires favourable conditions. In this respect, the
contribution of central banks is to secure one of the major conditions - price stability.
And inflation?
This raises the question of whether the exceptionally expansionary monetary policy will lead
to inflation in the long term. In most financial systems, surplus liquidity has reached historical
dimensions. Under normal circumstances, monetary developments of this kind would point to
a rise in inflation. Yet at the moment, rates of inflation in advanced economies are trending
downwards. As the recent reduction in the ECB reference rate shows, concerns about
deflationary trends are more predominant in the euro area at present.
Neither can any inflationary threats be identified for Switzerland. The SNB's conditional
inflation forecast from September (cf. chart 10) shows a very small increase in inflation to
2015, despite the assumption that the three-month Libor remains at zero over the entire
period. Explanations for this low level of inflation include the fact that the output gap is still
negative in Switzerland, the Swiss franc is strong, and commodity prices are stable or even
declining. We are keeping a very close watch on price developments, and we have the
necessary instruments to correctly assess any inflation or deflation risks and counter them
with appropriate measures.
Concluding remarks
Is a return to normal on the horizon? Yes, but much more slowly than expected. Overall,
financial markets have calmed and risk markets have strengthened considerably. The
exceptional measures taken by the central banks made a major contribution to these
developments, and in most cases, these measures are still in place. Thus it is clear that
monetary policy is still far from returning to normal. The fact that international monetary
policy is still very expansionary is not surprising, in view of the slow recovery of the global
economy.
As far as Switzerland is concerned, the minimum exchange rate will remain a necessary
instrument for the foreseeable future. Even today, the value of the Swiss franc remains high,
and there are no inflation risks. With interest rates at zero, the minimum exchange rate
prevents an undesired tightening of monetary conditions in the event that the upward
pressure on the Swiss franc should intensify once again.
Thus we remain prepared to enforce the minimum exchange rate by buying foreign currency
in unlimited quantities if necessary, and to take further measures as required. Consequently
the monetary policy we have conducted to date will continue to apply without any restrictions.
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