What does the end of the Swiss Peg tell us about central banks?

A lot of the discussion in blogs about the end of the Swiss exchange rate peg has focused on whether the original peg, which started in September 2011, was a good idea in the first place. [1] This post asks a rather different question, which has wider relevance.

First some facts, which you can skip if you have already read some of those posts. The safe haven status of the Swiss Franc meant that during the Eurozone crisis people wanted to buy the Swiss currency, and the resulting appreciation was in danger of driving some Swiss producers out of business. [2] The chart below plots competitiveness, measured as relative consumer prices, in Switzerland and in the UK. [4]

      

The appreciation problem in 2011 was real and the exchange rate cap fixed that, but to prevent the exchange rate appreciating beyond the 1.2 Swiss Francs (CHF) per Euro mark the central bank had to create lots of money to buy Euros. You can think of it as Quantitative Easing (QE) that buys foreign currency rather than domestic government debt. [3]

The interesting question is why the central bank ended the cap. Perhaps the cap was always meant to be a transitional measure, to allow firms time to adjust to a loss in competitiveness. (Here is the official explanation.) This is not that convincing. If the central bank was worried that its producers were becoming too competitive, it could have changed the cap from, say, 1.2 CHF per Euro to 1.1 CHF per Euro. Removing the cap completely would only make sense if you thought your safe haven status had reached some kind of equilibrium, and with the Greek elections and other things currently happening that seems unlikely. Even if you did think this, caution might suggest testing the market with a more appropriate cap and seeing how much defending you had to do.

As a result of ending the peg, the Swiss Franc has appreciated substantially, from 1.2 CHF per Euro to around 1 CHF per Euro, even though the central bank has lowered the interest rate on sight deposit account balances that exceed a threshold to −0.75%. There seem to be two alternative interpretations.

The first is that the central bank simply made a serious mistake. For some, the mistake was to impose the cap in the first place. If you do not take that view, and assuming the market’s immediate move is not a very temporary overreaction, the large appreciation partly undoes the benefits of the original peg. Either way, a major mistake has been made at some point. This can be added to what is now a seriously long list of recent major central bank mistakes: see in particular Sweden and the Eurozone. Does the fact that central banks in the UK and US seem rather less error prone have something to do with the greater influence of economists (inside and outside) on those banks? [5]

The second interpretation is that the open ended money creation that the policy implied just became too much for the central bank. In theory the central bank could go on creating money and buying Euros forever. As long as the exchange rate peg was reasonable this policy could be consistent with its inflation target (the target is ‘below 2%’, while actual inflation is currently negative). If it ever decided it was not and there was too much Swiss money around, the policy could be reversed by selling Euros. The central bank might make a loss when this was done, but economists generally dismiss this as a non-problem (a central bank is not like a commercial bank), just as they dismiss the same problem with conventional QE. But perhaps central banks do not see things this way (HT MT), because they worry about the political consequences of such losses. If this is the case, then this is something that economists need to respond to in one way or another.  

[1] The discussion in the media, as often with mediamacro, is obsessed with the markets. The Guardian had a link entitled “Swiss franc - what the economists say”. What you got were 6 City economists, who wrote the kind of thing City economists write. Now I’m sure the Guardian will say they needed something fast, and academics - even academic bloggers - are unreliable in that respect. But please label this properly: you are getting the reactions of City economists, whose primary concern is what this all means for the markets, and not what it means for ordinary people.

[2] Economists have a theory, Uncovered Interest Parity (UIP), which says that short term capital flows like this should not influence exchange rates, because the market will keep rates close to fundamentals. It does not work too well, partly I suspect because the market has little idea what the fundamentals are, and partly because no one in the market is prepared to take bets that last years rather than days.

[3] Switzerland has a really large current account surplus, which since 1997 has averaged 10% of GDP. The reason for this surplus is complex, but it suggests that there is scope for a gradual real exchange rate appreciation over time.

[4] Source: OECD Economic Outlook. The level is arbitrary, at 2010=100. A rise is an appreciation, which means a loss of competitiveness. The average level of this measure of Swiss competitiveness was around 96.5 from 1998 to 2004.

[5] However the suggestion by Tony Yates that every blogger should be given a job at the SNB seems to be going too far.