Jean-Pierre Danthine: Monetary policy is not almighty
Speech by Mr Jean-Pierre Danthine, Vice Chairman of the Governing Board of the Swiss
National Bank, at the Journée Solutions Bancaires, Geneva, 31 May 2012.
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Ladies and gentlemen,
It is a great pleasure for me to be here with you all today. At the outset, please allow me to
Journée Solutions
thank the organisers at Unicore for having invited me to speak at the 14th
Bancaires to be held here in Geneva.
Today, I will reflect on what monetary policy can and cannot do. I would like to emphasise
where central banks' powers and responsibilities end and where those of fiscal policy and the
private sector begin. "Why is he focusing on this now?" I hear you ask. "We are in the midst
of a crisis. Shouldn't he be emphasising what central banks can do, instead of what they
cannot?" My answer to you is this: while the monetary policy measures taken in recent years
have had a stabilising effect, today, monetary policy has acquired a degree of prominence
that could lead to its powers and its reach being overestimated. Central banks are far from
almighty and, in efforts to emphasise this, I will review the various policy options at the zero
lower bound and the risks associated with the measures currently in place. I will first examine
the issue in universal terms, before concentrating on the very unusual case of Switzerland.
Conventional policy options at the zero lower bound
Conventional macroeconomic theory states that, when interest rates are at the zero lower
bound, monetary policy becomes ineffective and economic policy action should concentrate
on fiscal measures. In slide 1, the depiction of the economy using the standard IS/LM model
summarises this point of view. As you can see, the economic situation is represented in
terms of two key variables, the interest rate and output (or GDP). Economic equilibrium is
represented by the intersection of the IS and LM curves. The first corresponds to the interest
rate and GDP levels that balance savings and investment and the second represents the
combinations of these two variables, which equilibrate the demand and supply of money.
Expansionary monetary policy corresponds to pulling the LM curve to the right. When interest
rates are at the lower bound, however, the LM curve is horizontal. At this point, pulling a
horizontal to the right has absolutely no impact on the intersection of the IS and LM curves,
and therefore on the equilibrium level of output. Conventional monetary policy hence
becomes ineffective. Intuitively, if interest rates are at the zero lower bound they cannot be
lowered further, yet it is precisely by lowering interest rates that monetary policy can stabilise
the real economy.
By contrast, it is at the zero lower bound that the potential benefits of fiscal policy are most
significant. As the same diagram suggests, it is precisely when the LM curve is flat that it
becomes most appealing to use fiscal policy. This is because a fiscal stimulus is not
counteracted by an increase in interest rates - that would lead to a what is known as a
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"crowding out" of private investment and thus fully translates into increased output (slide 2).
The challenges associated with fiscal imbalances
Of course, the functioning of a IS/LM model is simpler than that of the real economy. In
practice, the effectiveness of fiscal policy, even at the zero lower bound, is more ambiguous.
There are several reasons for this. Governments' decision-making processes can be
laborious, for example, so fiscal stimulus may not be implemented when it is most needed.1
Similarly, it may take time for fiscal stimulus to take effect or, in the case of a small open
economy, it may simply evaporate in the form of increased imports. Whatever the case may
be, the root of the current challenges is different. It resides in the fact that many countries
now have very little leeway with which to undertake fiscal policy manoeuvres. As a result, it is
becoming increasingly difficult, sometimes impossible, for public authorities to use fiscal
policy to support the recovery, even when this may seem appropriate.
Most mature economies would have been in a better position to address the current situation
if their fiscal reserves had been more significant at the onset of the crisis. In several cases,
public debt-to-GDP ratios were already around 60% or even above. Yet, since 2008, many
governments have actively used fiscal policy to combat the effects of the crisis and to
refinance the banks. As a result, the debt-to-GDP ratios of G7 countries, for example, have
increased by an unweighted average of almost 30 percentage points (slide 3). As a
consequence, today, the option of implementing new fiscal stimuli has been virtually ruled
out.
Monetary policy: in the frontline once again
When it comes to economic policy matters, central banks have, therefore, returned to the
limelight somewhat by default.
In the current crisis, monetary policy has proved more effective than the IS/LM model might
suggest. This is essentially because central banks have resorted to using various
combinations of conventional and unconventional measures to help provide conditions
conducive to economic growth in a context of deflationary risks . Here, the aim has often
been to impact long rates directly, given that it was no longer possible to influence short-term
rates. Several central banks have therefore purchased assets to put pressure on their
longerterm yields (quantitative easing). To the same end, some have extended the maturity of the
assets on their balance sheets, while others have purchased private sector assets to
contribute to the easing of market conditions (credit easing). Meanwhile, others have
conducted foreign exchange interventions to reduce pressure on the export sector and to
ease monetary conditions. Many have also made implicit or explicit long-term commitments
to foster expectations of future low rates.
The scale of central bank intervention has been significant, as indicated by the combined
balance sheets of central banks in the US, the UK, the euro area, Japan, China and
Switzerland, for example. The total now amounts to some USD14 trillion (slide 4), i.e. over
30% of GDP in these currency areas. These exceptional monetary policy measures do,
indeed, appear to have exerted downward pressure on interest rates, thus sustaining the real
economy in the spirit of the IS/LM model.
What are the risks associated with these policies?
Despite these positive (short-term) effects, I would first like to argue that the general
message of the IS-LM diagram has not been invalidated by recent central bank actions. That
is to say, when interest rates are close to zero, it is most appropriate to resort to fiscal policy
and monetary policy becomes less effective.
Moreover, the current policy-mix can entail risks, to which I would now like to draw your
attention. My greatest concern is that the general public could come to overestimate the
impact of central banks' actions and the suitability of their intervention in each and every
economic situation that is deemed "unsatisfactory". This could result in central banks being
perceived as all-powerful, though such expectations are far from realistic. Troubled financial
markets and dangerous economic circumstances required the implementation of exceptional
measures. Even if these measures have a welcome impact in the short term, central banks
must remain focused on their core mission, which is to ensure price stability. This is their
long-run contribution to economic well-being. Monetary policy does not create wealth in and
of itself. It is the innovative and entrepreneurial strengths of the private sector, not short-term
monetary policy measures, that are the engines of real sustainable growth.
Could the short-term liquidity-creating measures pose a risk for price stability? This risk is
often alluded to, and central banks are acutely aware that any measures must be rigorously
and repeatedly assessed to prevent any mid-term resurgence of inflation. In any case, there
are well-identified means of quickly reversing the effects of an abundance of liquidity, though
it is true that the timing of such "exit" measures is a matter of delicate monetary policy
assessment.
Today, however, abundant liquidity and extended periods of low interest rates are recognised
as posing a risk to financial stability. One of the lessons of the recent crisis is that price
stability is not sufficient for financial stability. Many central banks are therefore placing
greater weight on financial stability concerns in their decision-making processes. To this end,
several now envisage the use of specific new ("macroprudential") instruments to directly
address the risks to financial stability.
It is also worth considering whether central banks' recent activism could undermine their
independence. Several critics claim that, by implementing measures such as quantitative and
credit easing, central banks have, at times, adopted "quasi-fiscal" policies and that the
boundaries between fiscal and monetary policy were, thus, blurred. Yet, central bank
independence is a delicate democratic concept. Its objective is to prevent temporal
inconsistencies in the policies pursued from leading to results that could harm the economy
as a whole. In other words, independence enables central banks to focus on price stability in
the long-term interests of a country, as opposed to prioritising the short-term demands of
specific political or economic interest groups. At present, the use of unconventional
measures is largely motivated by the fact that monetary policy is at the zero lower bound and
fiscal policy options are very limited. These are exceptional responses to exceptional
circumstances and should remain so.
Finally, it is important to acknowledge that, by expanding their balance sheets, central banks
have had to assume increased financial risks. Many central banks have purchased bonds
when interest rates were very low. They are therefore exposed to considerable interest rate
risks, which could lead to significant balance sheet losses and even to negative equity
positions. In the short term, this is not a problem as it does not affect a central bank's
capacity to fulfil its mandate. After all, as a central bank has banknote-issuing privileges, it
cannot become illiquid. Moreover, it is normally in a position to rebuild its equity in the longer
term. Nevertheless, it is not desirable, even for a central bank, to experience a long period of
negative equity as this could generate doubts about its credibility.2
Switzerland: a very special case
Although the recent crises have been global in nature, every country has had to define policy
in response to the specific circumstances that affect it. The Swiss case is very special as our
country still has the leeway to undertake fiscal manoeuvres. Instead, we are confronted by
another major challenge, the exceptional power of our currency. As we all know, the
increased uncertainty and extreme risk aversion, which arose as a result, drove the Swiss
franc to an all-time high in early August of 2011, posing a threat to the economy and carrying
the risk of severe deflationary developments. As I already mentioned, fiscal policy remained
a conceivable means of addressing this problem as our country's debt-to-GDP ratio is less
than 40% and its public sector budget has been in surplus for the last six years. It was not,
however, as the massively overvalued Swiss franc first threatened demand for Swiss exports
and Switzerland is, of course, not in a position to stimulate the entire world economy. In this
particular case, it was inappropriate to resort to fiscal policy. It was therefore up to the SNB
to take action. It implemented measures aimed at a substantial and sustained weakening of
the Swiss franc. After provoking an exceptional increase in liquidity in August, on
6 September 2011 the SNB announced that it would no longer tolerate a EUR/CHF
exchange rate below CHF 1.20. This measure remains the focal point of Swiss monetary
policy. In the current global context, Switzerland's economic situation does not justify any
strengthening of monetary conditions and this should remain the case for the foreseeable
future. The SNB continues to enforce this minimum rate with the utmost determination and
remains prepared to buy foreign currency in unlimited quantities for this purpose.
From a conceptual perspective, the minimum exchange rate is not a quantitative easing
measure and most of my generic comments do not strictly apply to the Swiss case.
Nevertheless, the risks associated with this measure do, to a certain extent, resemble those I
just described. The first of these risks is that the minimum exchange rate may superficially
seem like a simple or straight-forward measure, which may in turn give the impression that
monetary policy is a catch-all problem-solver, i.e. that it is almighty. This is clearly not the
case. Monetary policy has neither the capacity nor the mandate to protect the Swiss
economy from all the shocks to which it is subjected. The aim of the minimum exchange rate
is to avert the worst possible developments in zero interest rate environment. It is not a
response to each and every challenge with which the Swiss economy is faced, nor can it be
implemented at any desired level, free of any risk.
The SNB's mandate is still to ensure price stability. The minimum exchange rate has
decreased the deflationary and recessionary risks associated with a massively overvalued
currency. It is entirely in line with our mandate. Furthermore, there is no risk of inflation in
Switzerland for the foreseeable future. However, the SNB does recognise that the long
period of low interest rates we are experiencing constitutes a danger to the stability of the
financial system. The domestic credit and real estate markets are vibrant and there are
concerns about the possible build-up of imbalances, which could eventually lead to price
corrections and substantial losses in the Swiss banking sector. There is no doubt, however,
that, in the current context of global economic indications of downside risks to the Swiss
economy, current interest rate levels and the minimum exchange rate are vital. Any concerns
about the housing market must, therefore, be addressed by alternative means. The SNB thus
advocates the introduction of a "countercyclical capital buffer", a macroprudential tool
targeted at the specific situation we are experiencing. If the SNB's recommendations are
implemented, the banks will be legally obliged to meet specific equity capital requirements as
soon as certain indicators on the real estate and mortgage markets show signs of
unsustainable growth.
The concept of central bank independence is widely recognised in our country. The fact that
an independent monetary policy best serves the interests of the country is rarely disputed. In
the current exceptional circumstances, the imposition of a minimum exchange rate is a
measure that has received strong support from economic and political actors in Switzerland
and abroad. Both the IMF and the OECD recently confirmed that this was an appropriate
response3 to the risk of economic contraction and deflation in our country.4 Given the perfect
alignment of this exceptional monetary policy measure with the pursuit of the SNB's price
stability mandate, one would imagine that, in the future, the National Bank's independent
status will remain as strongly anchored as in the past.
Finally, it is important to consider the risks associated with the SNB's inflated balance sheet.
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Our balance sheet has become more volatile, principally because it has grown in size it is
four to five times larger than it was in 2007 - but also because of the volatility of the overall
environment. In the course of the last two years, risks have manifested themselves both
positively and negatively. In 2010, for example, the SNB experienced its biggest ever loss,
but in 2011, it also experienced one of its largest gains. The much increased size of our
balance sheet, the unavoidable exchange rate risks associated with our foreign exchange
reserves and a dependence on developments in the gold and capital markets, mean that the
high volatility of the SNB's annual results will be a standard feature of the near future.
In this respect, it is important to emphasise that monetary policy considerations always take
precedence over those regarding the SNB's balance sheet risks. It is therefore worth
repeating that there is a very high level of uncertainty in the international environment. An
appreciation of the Swiss franc would again expose the Swiss economy to considerable risks
and, once more, endanger both price stability and economic situation. Given this state of
affairs, the SNB will continue to enforce the minimum exchange rate with utmost
determination and, should the economic outlook and the threat of deflation require, is
prepared to take further measures at any time.
Concluding remarks
In closing, I would like to summarise my message. The unconventional measures the SNB
and several other central banks continue to implement are tailored responses to exceptional
circumstances. Their impact should nevertheless not be overestimated, and the associated
risks must be recognised. Central banks are the guardians of price stability. Taking the broad
economic situation into consideration, they can promote conditions that are conducive to
growth. But central banks are not almighty. Monetary policy does not create wealth in and of
itself, only financial and economic actors can harness the very best of their innovative,
technological and creative talents to generate value and promote sustainable growth.
References
Gurria, Angel, OECD Secretary-General. 2012. "Policy priorities for a stronger, cleaner and
fairer Swiss economy." Remarks delivered at the launch of the 2012 OECD Economic
Survey of Switzerland. 24 January 2012.
International Monetary Fund. 2012. Switzerland: 2012 Article IV Consultation - Staff Report;
Public Information Notice on the Executive Board Discussion. Statement by the Executive
Director for Switzerland. IMF Country Report No. 12/106. May 2012.
Jordan, Thomas. 2011. "Does the Swiss National Bank need equity?" SNB. Speech to the
Statistisch-Volkswirtschaftliche Gesellschaft. Basel. 28 September 2011.
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