Stefan Elfwing On Swiss Monetary Policy

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Stefan Elfwing sent me a very good comment regarding the recent spate of posts on the Swiss National Bank’s exchange rate peg:

The Swiss data was not totally correct. . . . And there was no inflation in April. It decreased slightly to -0.99% from the -0.95% rate in March. The deflation expectations now seem anchored at about -1%.

The mean of the eur/chf average annual exchange rate 2002-2009 was about 1.55 (min:1.47 max: 1.64). The floor of 1.2, which has become, binding then represents an approx 29% stronger swiss franc than the “normal” level. It is kind of the evil twin of LEO S [Svensson's] failproof method, create deflation expectations instead of inflation expectations.

So, I really don’t understand the Swiss hype among the NGDP crowd. Yes, expectations works extremely well for central banks. But, central banking is not about “proving” theoretical hypotheses and using the theories for evil purposes.

The exchange rate figures are presumably nominal and hence slightly overstate the Swiss franc overvaluation, but I accept his point. I think many people (perhaps including me) have become too excited about the Swiss policy. Stefan’s right, it is too deflationary. Indeed it’s not a good idea to peg your currency to another currency, you should adjust monetary policy according to the needs of the domestic economy.

Other commenters pointed out that the SNB might abandon the peg tomorrow, if a eurocrisis causes a huge flood of money to pour into Switzerland. That’s true, but it’s not really relevant. Here’s what the Swiss case actually showed:

1. The standard assumption is that monetary stimulus requires a larger monetary base, an enlarged central bank balance sheet. That might be true in some cases, but in many cases exactly the opposite is true. Last summer the Swiss monetary policy was so contractionary that the SF was soaring in value. That naturally made lots of people want to hold SFs, and to keep the franc from soaring even faster, the SNB rapidly increased its balance sheet.

2. Then the SNB then decided to ease monetary policy, by depreciating the SF and then pegging it at 1.2 per euro. Now it was a less attractive investment, and the SNB balance sheet stopped increasing in size.

That was the point, it takes more “effort” to do a failed monetary policy than a successful one, a point I often make in the US context. Now I regret not indicating that even the current Swiss policy is far from optimal. As Stefan points out the SF is still overvalued, and hence Switzerland has deflation. By the way, it’s interesting to compare Japan and Switzerland, which both have very overvalued currencies, as both suffer from mild deflation. Many people who have never studied international economics actually claim these currencies are undervalued. They say that because both countries have current account surpluses of close to $100 billion. But never reason from a CA balance, it tells us nothing about whether the currency is under or overvalued. Indeed both countries have capital account deficits of roughly $100 billion, so by that logic one could argue their currencies are undervalued. The only meaningful measure of under or overvaluation is relative to what is required to achieve macro equilibrium in the domestic economy. If a country has (unwanted) deflation, then ipso facto its currency is overvalued

P.S. There is a separate issue of government saving. Some economists like Paul Krugman claim the Chinese currency is undervalued because their government saves too much. I don’t agree, but that’s better thought of as being an argument about government saving, not monetary/exchange rate policy. And BTW, it has nothing to do with the Chinese government artificially controlling the nominal exchange rate—it’s the government saving that reduces the real exchange rate for the yuan, it would happen even if the yuan was floating.

P.P.S. If the Swiss insist on pegging the franc, they should do a crawling peg with a gradual depreciation over time.