Fritz Zurbrügg: After the minimum exchange rate - new monetary policy
challenges
Speech by Mr Fritz Zurbrügg, Member of the Governing Board of the Swiss National Bank, at
the Money Market Event, Zurich, 26 March 2015.
* * *
The speaker would like to thank Dirk Faltin for his valuable support in preparing this speech. He also thanks
Marco Huwiler and Peter Kuster for helpful comments.
Accompanying charts can be found at the end of the speech.
Ladies and gentlemen
A warm welcome to our traditional Money Market Event in Zurich. We are delighted that so
many of you accepted our invitation to attend. A year ago at this gathering, I spoke to you
about the Swiss National Bank's (SNB) investment policy. At the time, I touched only
peripherally on monetary policy and the minimum exchange rate of CHF 1.20 per euro. It will
come as no surprise to you that this year I have decided to devote my talk exclusively to
monetary policy.
On 15 January of this year, the SNB discontinued the minimum exchange rate to the euro.
This step attracted a good deal of attention around the globe and triggered dramatic price
movements on the financial markets for a short time. It has significant implications for large
sections of Switzerland's economy. For the SNB, too, the decision to discontinue the
minimum exchange rate was a momentous one.
I would like to take this opportunity to explain our rationale for discontinuing the minimum
exchange rate in more detail. In doing so, I shall also outline the consequences of this
decision for the economic outlook and price developments in Switzerland. Let me start by
reminding you of the circumstances surrounding the introduction of the minimum exchange
rate in September 2011. After my presentation, my colleague Dewet Moser will brief us on
this latest chapter in monetary policy implementation.
From financial crisis to minimum exchange rate
The international financial crisis started almost eight years ago. In August 2007, extreme
tensions became evident on the money market. Central banks in the advanced economies
countered these developments by lowering key interest rates and expanded the liquidity
supply to the interbank markets. As the banking crisis increasingly broadened into a wider
financial and economic crisis, demand for safe investments - and hence also for Swiss
francs - increased rapidly. From the end of the year, the franc came under substantial
upward pressure (cf. chart 1). Following the collapse of Lehman Brothers in autumn 2008,
central banks quickly reduced short-term interest rates to unprecedented lows. At the
beginning of 2009, the SNB lowered the target range for the three-month Libor to between
0% and 0.75%. The one-week repo rate, which is used to steer the Libor, had already been
close to zero since the end of 2008. Conventional monetary policy - that is to say, the
steering of the economy via short-term interest rates - had thus come up against its limits.
However, fears that monetary policy had run out of options were unfounded. Central banks in
the advanced economies increasingly began to resort to unconventional instruments. At the
SNB, these included long-term repos, purchases of Swiss franc-denominated bonds issued
by domestic, private-sector borrowers and interventions in the foreign exchange market. It is
worth noting that the SNB had intervened only very rarely in the foreign exchange markets
between the early 1980s and 2009. And on the occasions when it had, the SNB's
interventions had typically been small-scale and had been coordinated with the Group of Ten
central banks.
This changed in March 2009, when, having reduced the short-term interest rate to near zero,
the SNB began purchasing foreign exchange in an effort to counter upward pressure on the
Swiss franc and prevent an undesirable tightening of monetary conditions. The first
escalation in the euro area debt crisis in the spring of 2010 required the SNB to make
extensive foreign currency purchases; these were provisionally halted in June 2010 once the
economic recovery had gained a foothold.
In the first half of 2011, the situation in the euro area took another turn for the worse. Other
euro area countries were being dragged into the crisis. The global economic outlook
deteriorated and uncertainty on the financial markets was compounded by the US budget
dispute. Upward pressure on the Swiss franc was immense at this time. In August 2011, the
real export-weighted Swiss franc exchange rate was 40% above its long-term average
(cf. chart 2).
In August 2011, in an attempt to counter the exceptionally strong Swiss franc, the SNB
narrowed the target range for the Libor to between 0.0% and 0.25%, aiming to keep it as
close to zero as possible. It also took steps to expand banks' sight deposits significantly.1
These measures were successful up to a point, however in the light of ongoing uncertainty
on the financial markets and more bad news from the euro area, upward pressure on the
Swiss franc remained high and became more intense still at the beginning of September
2011. The SNB therefore decided to provide the foreign exchange market with clear
guidance in the form of a minimum exchange rate for the franc against the euro. On
6 September 2011, it announced that it would no longer tolerate a EUR/CHF exchange rate
below CHF 1.20.
This exceptional measure enabled the SNB to take a stand against an acute threat to the
Swiss economy and to counter the risk of a deflationary trend emanating from the massive
overvaluation of the Swiss franc. The minimum exchange rate was introduced as a
temporary, emergency measure in a time of extreme turbulence. The franc remained high in
the period that followed, yet deflation risk was held in check. Moreover, the minimum
exchange rate bought Swiss companies - especially exporters and industries facing
competition from imports - some time in which to plan their next steps in a very difficult
operating environment.
Discontinuation of the minimum exchange rate
The minimum exchange rate has undoubtedly served Switzerland well during an exceptional
period. However, the old adage popular among economists - "there's no such thing as a free
lunch" - holds true for monetary policy as well. The SNB Governing Board was well aware
that the introduction of a minimum exchange rate would entail certain risks - and we
consistently alluded to these. That the SNB would have to make large foreign currency
purchases and expand its currency reserves in order to enforce the minimum exchange rate
was thus to be expected. The SNB must be willing to bear these risks if doing so is
necessary for the fulfilment of its legal mandate, and if these risks are justified given the
chances of success.
We enforced the minimum exchange rate consistently for more than three years
(6 September 2011 to 15 January 2015). At the peak of the euro crisis in 2012, the SNB had
to purchase CHF 188 billion of foreign currency. Adding this to purchases from prior years
reveals that the SNB's currency reserves rose from CHF 50.5 billion in 2007 to
CHF 432.2 billion at the end of 2012 (cf. chart 3), proving beyond doubt that the SNB is
willing to accept balance sheet risks in order to enforce its monetary policy. Last year, the
SNB's shareholders, the Confederation and the cantons all learned that these risks can have
real consequences. For the year 2013, for the first time in its history, the SNB was unable to
pay any dividends or distribute any profit, as the fall in the gold price and exchange
raterelated losses had led to a very negative annual result. As you might expect, this decision
was not greeted with rapturous applause. However, the critical point here is that the
principles of the SNB's profit distribution agreement were not called into question. People
generally recognised and accepted the fact that a larger balance sheet goes hand in hand
with higher potential loss.
Despite having successfully enforced the minimum exchange rate of CHF 1.20 per euro for
several years, in January 2015 the SNB concluded that the measure had become untenable
and was therefore no longer justified from a monetary policy point of view. What led to this
far-reaching reassessment? Let us briefly re-wind to 2014. While in the US expectations of
an interest rate rise were mounting, there were signs of further monetary policy easing in the
euro area from mid-year onwards. The euro subsequently weakened significantly against the
US dollar. This in turn affected the EUR/CHF rate, which had already been close to the
minimum exchange rate for some time. As a result, the Swiss franc largely followed the euro
downwards. Nevertheless, at the mid-December monetary policy assessment, we were still
convinced that the minimum exchange rate was the right instrument for ensuring appropriate
monetary conditions. Shortly thereafter, however, the euro depreciation gathered pace
sharply, and pressure on the franc increased dramatically. It became clear that a minimum
exchange rate of CHF 1.20 per euro was no longer tenable. Only sustained currency market
interventions of rapidly increasing magnitude would have allowed the SNB to uphold the
policy.
Faced with these fundamental changes in international conditions, we came to the
conclusion that the minimum exchange rate could only have been maintained through an
uncontrollable expansion of the balance sheet, potentially even to a level several times
higher than Swiss GDP. The risks associated with such a balance sheet expansion would
have been out of all proportion to the benefits for the economy. An uncontrollable expansion
of the balance sheet would have severely impaired the SNB's ability to conduct monetary
policy in the future and jeopardised the fulfilment of its mandate in the long term. On the one
hand, the future use of currency interventions would have been severely constrained. On the
other hand, reabsorbing this huge volume of liquidity once monetary policy began to
normalise would have been very difficult and extremely costly.
Communication and timing of the discontinuation
The discontinuation of the minimum exchange rate took the financial markets by surprise and
the price reactions on the foreign exchange and equity markets were correspondingly strong.
In an age when transparency and openness in monetary policy matters are riding high, the
decision to exit the minimum exchange rate policy so abruptly bewildered many observers.
However, transparency is not an end in itself; it is part of monetary policy. Traditionally,
monetary policy has been steered via short-term interest rates. These then feed through to
exchange rates and long-term interest rates, thereby influencing - albeit with a time lag - the
demand for goods and services and, ultimately, wages and prices in the economy. By
communicating its intentions transparently and credibly, the SNB can influence expectations
(e.g. on the financial markets), thereby rendering its monetary policy more effective.
Fundamentally, we are keen to avoid surprising the economy and triggering major price
movements on the financial markets with our monetary policy measures. In the context of
conventional interest rate policy, it is thus advantageous to keep the gap between financial
market participants' expectations and the SNB's actual interest rate adjustments within
reasonable limits. Normally, therefore, there is no contradiction between the notion of
transparent communication and our monetary policy intentions.
But there are exceptions, and the discontinuation of the minimum exchange rate - a
measure that was directly linked to the foreign exchange market - is one such exception. An
announcement, or even the slightest hint of an imminent decision to dispense with the
minimum exchange rate, would have triggered massive speculation against the SNB. We
would then have been forced to, as it was, subsidise this speculation via foreign currency
purchases.
Incidentally, these same arguments also explain why a gradual exit from the minimum
exchange rate or a "gentle" transition to a policy involving some other form of explicit
exchange rate linkage (e.g. pegging the Swiss franc to a basket of currencies) was
impractical. Such a policy would likewise have opened the floodgates to speculators. There
was thus no reasonable alternative to exiting the minimum exchange rate suddenly and
completely.
We discussed when would be the best time to communicate the decision. Our choice of the
morning of 15 January was designed to allow market participants to start from a level playing
field when adapting to this undoubtedly challenging new situation. By discontinuing the
minimum exchange rate on a weekday when market participation was high, we minimised
the risk of some banks and their customers being put at a disadvantage, or of individual
participants gaining an advantage. At such a time, it would be possible for established
market access channels, via electronic trading platforms or phone links to the trading desks
of the main currency trading firms, to be widely used - although there were some bottlenecks
immediately after the announcement. By contrast, if we had announced the move at the
weekend, for instance, this would have caused uncertainty about the trading conditions when
the foreign exchange market opened on Sunday evening (Swiss time). Australia, which
normally accounts for only around 1% of daily turnover in Swiss franc forex operations, would
have been overwhelmed by the volume of trades during its business hours. You can easily
imagine that the turbulence on the Australian market would have been far greater than that
observed on the morning of 15 January, with contagion potentially spreading to the entire
financial market. We wanted to avoid this.
Monetary policy after the minimum exchange rate
So what will the minimum exchange rate discontinuation mean for monetary policy in
Switzerland? First, let me emphasise that the exit from the minimum exchange rate does not
mean that we will simply be a passive observer of the foreign exchange market in future. The
SNB will continue to take account of the exchange rate situation in formulating its monetary
policy and will intervene in the foreign exchange market as necessary in order to influence
monetary conditions.
Nonetheless, the end of the minimum exchange rate does mean that interest rate steering
will once again take on a more prominent role. In December last year, the SNB decided for
the first time to charge negative interest (-0.25%) on banks' and other financial market
participants' sight deposits at the SNB. On 15 January - concurrently with the discontinuation
of the minimum exchange rate - we lowered the interest rate again, this time to -0.75%. This
marked interest rate reduction was intended to cushion the blow of Swiss franc appreciation
and to counter a tightening of monetary conditions, by making it significantly more expensive
to hold Swiss francs compared to other currencies.
Negative interest rates have stimulated a lively public debate. This is hardly surprising given
that, in this form, such an instrument is something of a novelty that only a few central banks
have deployed.2 Apart from the SNB, the National Bank of Denmark, Sweden's Riksbank
and the European Central Bank have made use of negative interest rates to date.
Experience with this instrument is thus relatively limited.
Today, two months after negative interest rates were introduced, we can see that the
measure is working and having the desired effect on the money and capital markets. The
three-month Libor has been in negative territory since the announcement, dropping to a low
of -0.96%; it is currently roughly in the middle of the target range (cf. chart 4). Long-term
interest rates have also fallen, and the exchange rate too has now pulled back from the
extreme values observed immediately following the discontinuation announcement. In
tradeweighted terms, the Swiss franc is still at least 10% higher than it was at the beginning of the
year. Overall, the Swiss franc is significantly overvalued and should weaken with time.
When discussing the structure of the instrument, our deliberations focused on the interest
rate level, but also in particular on the exemption thresholds above which negative interest
was to be charged. We ultimately concluded that these thresholds should be calculated
according to the minimum reserves banks are legally obliged to hold. This is a method that is
both firmly anchored in law and for which clear rules exist.
As a result, banks with large Swiss franc holdings at the SNB relative to the size of their
balance sheets bear a heavier burden than banks with lower sight deposit balances. The fact
that the banks face differing burdens has been criticised in certain quarters. Some have
argued, for instance, that negative interest rates are distorting competition. This is certainly
not our intention. Negative interest is a monetary policy measure that - like any other form of
interest rate change - affects different industries and companies in different ways. Negative
interest is intended to make it less attractive to hold large amounts of liquidity in Swiss
francs. It is thus logical from a monetary policy perspective that banks which hold large
quantities of Swiss franc liquidity relative to the size of their balance sheets should shoulder
a heavier burden.
As already mentioned, the introduction of negative interest rates on sight deposits at the SNB
has also caused longer-term interest rates to fall. And yet, we have been living through a
period of exceptionally low interest rates for around six years already, with even long-term
investments bearing virtually no interest. The Swiss are a nation of savers and many people
are concerned about low interest rates. I understand this, however we should not forget that
what really counts for savers is not the nominal but the real (i.e. inflation-adjusted) interest
rate. For some time now, inflation has been very low and now it is even negative. If inflation
is negative, the real interest rate is higher than the nominal interest rate. As chart 5 shows,
there have often been periods in the past when real interest rates were even lower than they
are today.
During this challenging phase for the Swiss economy, it is important that the negative interest
rate be allowed to take effect and help to bring about a weakening of the Swiss franc. Efforts
to circumvent negative interest rates by obtaining exemptions or shifting to cash are not in
the interests of Switzerland as a whole in the current climate. Interest rate and exchange rate
developments in recent weeks suggest that our monetary policy measures are gradually
gaining traction.
Economic outlook
By introducing the minimum exchange rate, the SNB moderated the risks and adjustment
costs to which the Swiss economy was exposed and bought it some time to adjust to a
stronger franc. We are aware that the discontinuation of the minimum exchange rate will
mean that Switzerland has some difficult times ahead. The higher Swiss franc exchange rate
- and especially the speed of Swiss franc appreciation since the discontinuation of the
minimum exchange rate - is particularly challenging for exporters and industries facing
competition from imports.
In 2014, the Swiss economy recorded year-on-year growth of 2%. This increase was slightly
above long-term potential growth and reflects the robust state of our economy. The exit from
the minimum exchange rate has led to a deterioration of economic conditions. We thus
expect a much more modest expansion of real economic output this year of just under 1%. A
noticeable weakening in the economy may be expected, particularly in the first half of the
year. In the short term, significant underutilisation of production capacity may be expected
and unemployment is likely to increase moderately.
There is of course a particularly high degree of uncertainty attached to such forecasts. For
one thing, they will depend on how the Swiss franc exchange rate evolves in the coming
months. For another, it is not certain how international conditions will develop. The US
economy is more robust today than it was in 2011. The latest GDP figures for the euro area
are once again more reassuring, although the situation remains difficult. In addition, the
substantial fall in oil prices has had an easing effect. Despite all this, the risks - notably the
debt dispute between Greece and the rest of the euro area, as well as the crisis in Ukraine -
are not inconsiderable.
In the long term, I am confident that our economy will be able to cope with Swiss franc
appreciation. The currency has been strong in the past, and has a tendency to appreciate.
While a strong currency is an expression of a sound economy, it also presents companies
with major challenges, as an appreciating franc means higher prices for foreign customers
buying from Swiss firms. In order to remain competitive, this disadvantage has to be
continuously offset by adaptability, quality and innovation. Various competitiveness and
innovation indicators suggest that Swiss companies have been very successful on this score
in the past; the country regularly ranks among the leaders in these categories (cf. chart 6).
These findings inspire optimism, however it is important to remember two things. First, we
are dealing with averages here. When it comes to managing the new currency landscape,
the options available to individual industries and companies will vary greatly; and so, in turn,
will the impact of Swiss franc strength.3 Second, the extent of recent Swiss franc
appreciation presents Switzerland's economy with exceptional challenges which should
certainly not be underestimated. But one thing is clear: entrepreneurial thinking is remains
important. We have the utmost respect for this entrepreneurialism and for the employees
who are being called upon to support these adjustments.
Inflation outlook
Let me now turn to the inflation outlook. The SNB's mandate is to ensure price stability in the
medium term, while taking due account of economic developments. We remain committed to
maintaining price stability and the decision to exit the minimum exchange rate has not altered
our mandate in any way.
Last year, the inflation rate - as measured by the consumer price index (CPI) - hovered
around zero. This year, inflation will decline well into negative territory. This is first and
foremost due to two factors: Swiss franc appreciation since the discontinuation of the
minimum exchange rate and the sharp fall in oil prices. Last year, oil prices fell by some 40%
in Swiss francs. According to an economist's rule of thumb, this should translate to a decline
in CPI inflation of almost 1 percentage point. The low inflation we are witnessing is thus in
large part attributable to the collapse in oil prices. The important thing to remember here is
that the effects of both the Swiss franc appreciation and the oil price drop are temporary.
They will not jeopardise price stability.
We have revised our forecast downwards for the current year, from -0.1% to -1.1%. Inflation
is expected to reach its low point in the third quarter of 2015, at -1.2%. We anticipate
inflation of -0.5% for 2016. As you can see from chart 7, inflation will move back into positive
territory only at the start of 2017. These forecasts assume that the three-month Libor remains
at -0.75% over the entire forecast horizon, and that the Swiss franc weakens.
Our forecasts show that the period of negative inflation is temporary. The SNB's monetary
policy strategy provides for positive inflation rates of below 2% in the medium term. So as
long as the inflation rate returns to this range in the medium term, price stability will not be
threatened. The important thing is that medium-term inflation expectations remain within a
range that is compatible with price stability. While these inflation expectations have declined
substantially, they are still in positive territory. This is confirmed in regular surveys by
thirdparty providers, as well as in conversations between the SNB's delegates for regional
economic relations and company representatives from all sectors of the economy. Sustained
negative inflation, or even a deflationary spiral - a negative feedback loop involving an
economic downtrend and falling price levels - is thus not expected.
Closing remarks
In conclusion, let me reiterate that the minimum exchange rate was introduced as an
exceptional and temporary measure during a period of unprecedented turmoil for the
financial markets and the global economy. It served Switzerland well for more than three
years, partially correcting the massive overvaluation of the Swiss franc. Last year, monetary
policy in the euro area and Switzerland increasingly began to diverge. This was reflected in a
very sharp depreciation of the euro against the US dollar. A minimum exchange rate of CHF
1.20 per euro was thus no longer sustainable. The high and rising volumes of currency
intervention that would have been necessary to maintain the minimum exchange rate would
have resulted in an uncontrollable expansion of the SNB's balance sheet. In the long term,
this would have severely restricted its room for manoeuvre in monetary policy matters, and in
turn its ability to fulfil its mandate.
Given prevailing international conditions, the negative interest rate - and our willingness to
intervene on the foreign exchange market as necessary - give us the tools to ensure price
stability in the medium term. Seen from the current perspective, too, there is no threat to
price stability in the medium and long term. The impact of the appreciation on consumer
prices is temporary, although it may linger for some time. As regards economic
developments, we are aware that the discontinuation of the minimum exchange rate means
that there are difficult times ahead for Switzerland.
We have every confidence that Switzerland's economy and its economic agents will rise to
the challenge and adjust to the strong Swiss franc. The last few years have provided an
impressive illustration of just how exceptionally adaptable this country's entrepreneurs are.
The Swiss franc is significantly overvalued and while it is expected to weaken over time, until
it does, this substantial - and above all abrupt - appreciation of the currency will present
considerable challenges. I repeat: My colleagues on the Governing Board and I have great
respect for the business community whose task it will be to make these difficult adjustments.
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