Monetary policy under new constraints: challenges for the Swiss National Bank

Symposium contribution

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27 August 2022, 7.00 pm

Monetary policy under new constraints: challenges for the Swiss National Bank Jackson Hole Economic Policy Symposium: Reassessing Constraints on the Economy and Policy

Contribution to the panel 'The Outlook for Policy Post-Pandemic'

Thomas J. Jordan

Chairman of the Governing Board∗

Swiss National Bank

Jackson Hole, 27 August 2022

© Swiss National Bank

• The speaker would like to thank Claudia Aebersold, Gregor Bäurle and Christian Grisse for their support in preparing this speech. He also thanks Petra Gerlach, Carlos Lenz, Alexander Perruchoud and Tanja Zehnder, as well as the SNB Language Services.

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This year's Jackson Hole symposium seeks to reassess the constraints on the economy following the coronavirus pandemic and Russia's attack on Ukraine, with this panel focusing on the monetary policy outlook in particular. The pandemic and the war in Ukraine have fundamentally changed the constraints on conducting monetary policy. In the past, central banks have been constrained by the effective lower bound on interest rates, but at present it is the strong rise in inflation that poses the major challenge. Over the longer term, structural developments such as the decarbonisation of the economy, the high levels of sovereign debt worldwide and potential deglobalisation could shape the economic constraints and lead to heightened inflationary pressure.

I begin by looking back at the challenges central banks, and in particular the Swiss National Bank, have had to contend with since the global financial crisis. I will go on to highlight the developments since the pandemic and the outbreak of the war. The second half of my contribution will address in particular why an appropriately defined range for price stability and a narrow mandate are key factors in being able to conduct effective monetary policy over the longer term in an ever-changing environment. Here I will draw especially on the SNB's experience, taking the Swiss perspective of a small open economy with an important currency.

I. Aftershocks of the global financial crisis

In the two decades prior to the global financial crisis, the nominal interest rate level had declined worldwide. On the one hand, central banks' success in combatting inflation, coupled with cheap production opportunities resulting from an increasingly integrated global economy, had led to falling inflation rates. On the other hand, the real rate of interest had declined in many countries due to structural factors such as decreasing productivity growth and the ageing of the population.

When the global financial crisis and the associated economic slump required a decisive easing in monetary policy, many central banks quickly reached the zero lower bound on interest rates. To continue to ensure an appropriately expansionary monetary policy in this situation, 'unconventional' measures then had to be introduced.

Switzerland, too, was unable to escape these international developments. As a small open economy, in the wake of the financial crisis it was hit hard by the slump in global demand and the turbulence on the international financial markets.

Our country's situation was exacerbated by strong upward pressure on the Swiss franc. The rapid pace of the appreciation, and the resulting - at times massive - overvaluation of the Swiss franc, heightened the economic challenges and gave rise to the threat of deflation. On the one hand, the appreciation reduced global demand for goods and services produced in Switzerland, and the associated negative effects on the economy curbed inflation. On the other hand, the appreciation led directly to lower prices for imported consumer goods. Owing to the high share of imports in Switzerland, this weighed additionally on inflation.

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This pronounced appreciation pressure was attributable to two specific characteristics of Switzerland. First, the traditionally low level of interest rates in Switzerland meant that there was less leeway to the effective lower bound by international comparison. Interest rates in Switzerland are generally lower than abroad since the Swiss franc is valued as a safe investment given Switzerland's long-standing political, fiscal and monetary stability. As central banks lowered interest rates significantly due to the global financial crisis, the interest rate differential between Switzerland and other countries decreased, making the Swiss franc comparatively more attractive. Second, when risk sentiment deteriorates globally, our currency typically gains in value owing to its characteristic as a safe haven. This was especially the case during the financial crisis and the European sovereign debt crisis. Heightened uncertainty worldwide following the outbreak of the coronavirus pandemic and Russia's attack on Ukraine also increased upward pressure on the Swiss franc.

To ensure price stability over the medium term against this backdrop, the SNB resorted to unconventional measures. We lowered our policy rate well into negative territory and intervened in the foreign exchange market, at times considerably. This led to a marked expansion of our balance sheet (cf. Chart 1). The use of foreign exchange market interventions was necessary given that the strong appreciation of the Swiss franc was a direct source of the deflationary pressure in Switzerland. Furthermore, the scope for buying domestic bonds was limited given Switzerland's relatively small capital market.

By lowering our policy rate to −0.75% and extensively intervening in the foreign exchange market, we were able to ensure price stability even in these difficult years. Although there were phases when inflation slipped into negative territory, it always returned relatively quickly to positive values. There are two points worth noting in this regard.

First, the phases of negative inflation did not lead to a de-anchoring of longer-term inflation expectations. These remained consistently between 0% and 2%, i.e. in the range that the SNB equates with price stability. This can be seen in the inflation expectations of companies in Switzerland (cf. Chart 2). Although their short-term expectations tracked the development of inflation, their longer-term expectations remained stable even when inflation was temporarily negative. The companies regarded the recurring phases of negative inflation as one-off events. Although inflation has been very low on average over the past 15 years, companies have not perceived the decline in inflation as a trend. The companies apparently trusted that the SNB would be able to prevent a sustained decline in the level of prices through its decisive use of unconventional measures. The SNB was able to preserve its monetary policy credibility, even in this difficult environment.

The second point relates to the adjustment processes following the sudden upward surges in the value of the Swiss franc. The negative or very low inflation in Switzerland was in fact part of these adjustment processes, since it contributed to reducing the overvaluation of the Swiss franc over time. Thus, the real exchange rate appreciated considerably less than the nominal exchange rate (cf. Chart 3). This helped to cushion the impact of the nominal appreciation on

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the real economy. The economy's ability to adapt to an environment with low - and in some instances negative - inflation has been better than many expected.

The Swiss economy has fared relatively well over the past 15 years. The labour market has remained robust overall, and GDP growth has been good by international comparison

(cf. Chart 4). Like most other countries, Switzerland was unable to avoid significant declines in GDP amid the global financial crisis and during the pandemic, but each time our economy quickly returned to a growth trajectory.

The SNB was able to ensure price stability in the phase marked by deflationary risks, and thus contributed to a comparatively robust development of the economy. Of course, besides the influence of monetary policy, this development of the real economy also reflects structural factors such as the strong resilience of the well-diversified Swiss economy and the flexible labour market. Companies had to make considerable efforts to adapt to the difficult conditions after each appreciation surge, which may have enhanced the flexibility and efficiency of the Swiss economy even further. The increase in the population as a result of immigration made a positive contribution to growth as well. Furthermore, during the pandemic in particular, there was also a rapid and targeted fiscal policy response.

II. New constraints

The pandemic and the war in Ukraine have fundamentally changed the constraints on central banks. In particular, inflation has risen strongly in many countries over the past year, and uncertainty has also increased markedly in many respects.

The SNB, too, is at present confronted with an inflation rate that is significantly above the range we equate with price stability. As in recent years, inflation in Switzerland is currently lower than in many other countries. Besides the strong Swiss franc, the energy mix in Switzerland has thus far also helped to keep inflation comparatively low. Nevertheless, the current level of 3.4% is still the highest inflation our country has seen since the 1990s.

Furthermore, there are signs that inflation is increasingly spreading to goods and services that are not directly affected by the pandemic or the war in Ukraine. In fact, it appears that in the current environment, higher prices are being passed on more quickly - and are also being more readily accepted - than was the case until just recently. In conjunction with this, longer- term inflation expectations have also been moving upwards slightly over the past quarters. Furthermore, there are clear indications of wage growth gathering momentum.

How is the SNB handling this situation? We already made our initial response to the impending inflationary pressure in the final months of 2021. Both inflation and our inflation forecast at that time were still at a very low level. At our monetary policy assessment in December, we announced that we would allow the Swiss franc to appreciate to a certain extent in nominal terms in order to reduce the inflationary pressure from abroad. The Swiss franc gained around 4% in nominal terms between autumn 2021 and spring 2022, making imports cheaper and so countering the general increase in prices. In June 2022, we then raised

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the SNB policy rate for the first time in 15 years, by half a percentage point to −0.25%. At the same time, we signalled that further interest rate moves may be necessary in the foreseeable future. With our policy rate rise, the Swiss franc appreciated further.

The need for monetary policy tightening is shown by our conditional inflation forecast of June 2022 (cf. Chart 5). According to this forecast, and assuming that the SNB policy rate remains constant at −0.25%, the rate of inflation will temporarily decline before rising back to 2% over time. Had we not raised our policy rate in June, inflation would very probably have been well above this level over the medium term, and thus persistently outside the range of price stability.

Our monetary policy decision in June must also be seen as a weighing-up of various risks. Tightening too soon or too strongly could have stalled economic development, and possibly even led to renewed deflationary risks. In Switzerland's case, however, these factors were clearly outweighed by the risks of tightening too late. Waiting could have necessitated a more abrupt and stronger rate increase at a later date, with the risk of a more severe economic downturn and threats to financial stability. The SNB's experience in the late 1980s and early 1990s, the most recent phase of higher inflation in Switzerland, shows that it can become necessary to pursue a markedly restrictive monetary policy with serious consequences for the real economy once inflation exceeds a certain level. Our substantial change in course at a comparatively early stage regarding the development of inflation, and the fact that we envisaged possible further tightening in the near future, were thus aimed at ensuring price stability over the medium term without placing an excessively heavy burden on the economy.

This weighing up of various risks takes place in an environment marked by exceptional uncertainty. What does this uncertainty mean for the SNB? In the immediate term, the uncertainty above all pertains to the interpretation of the data currently available. In making our monetary policy decisions, it is important that we distinguish between temporary and sustained inflationary pressure. The recent rise in inflation may well have been triggered to a large extent by supply shocks with a temporary impact. However, given the difficulty in identifying an increase in sustained inflationary pressure in the current environment, there is the risk of underestimating the persistence of inflation. This is particularly the case because it is still very difficult to assess the impact of the highly expansionary monetary and fiscal policies worldwide in the wake of the pandemic and the war in Ukraine.

The uncertainty is also reflected in the fact that our economic models may be capturing the current situation less reliably than usual. We have in fact had to repeatedly make upward revisions to our inflation forecast in recent quarters (cf. Chart 6). Models are inherently unable to anticipate either shocks - such as in the case of energy prices - or fundamental shifts in the behaviour of economic agents - such as pricing behaviour - and therefore only capture their impact with a certain time lag.

It is very difficult at present to model companies' pricing behaviour due to the lack of experience with rapidly rising inflation. A combination of newer and traditional approaches are helping us to get a better understanding of the current data. On the one hand, micro price

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