Question

Read the posted article “As Swiss Economy Blooms, Central Bank Presents a Quandary,” from the March 15, 2018 Wall Street Journal (author Brian Blackstone) about the most recent policy decision by the Swiss National Bank (SNB), Switzerland’s central bank. Please note: Switzerland currently floats its currency. Then answer the following questions about the article:

Explain why the SNB decided to keep its policy rate at -0.75%. Use the EUD and r equations to help with your explanation.

Why does the author say that “the central bank is still in crisis mode?” (Hint: look at the reported indicators describing current Swiss macro performance.)

How has the low policy rate affected the Swiss housing market? Is this a potential problem?

Does this article suggest a potential conflict between internal balance (IB) and external balance (EB) in Switzerland?

Switzerland is facing a dilemma: The economy is growing but the central bank is still in crisis mode. It’s a contradiction that confronts many other wealthy economies in Europe, but it's one that is particularly striking in Switzerland. The economy is on the up but the Swiss National Bank has kept the deposit rate at its current level since January 2015, when the bank also unexpectedly abandoned a ceiling on the franc’s value against the euro. On Thursday, the SNB kept its key policy rate at minus 0.75%. “The negative interest rate and the SNB’s willingness to intervene in the foreign exchange market as necessary therefore remain essential. This keeps the attractiveness of Swiss franc investments low and eases pressure on the currency,” the SNB said Thursday. The euro traded at 1.1690 francs after the decision, little changed from Wednesday. Yet after a soft patch early last year, Swiss gross domestic product has expanded into the 2% annualized range recently. The unemployment rate was just 3.2% in January. Its trade surplus was 35 billion francs ($37.04 billion) last year, roughly 5% of Swiss GDP. In its policy statement Thursday, the SNB said it expects Swiss GDP to expand around 2% this year amid a broader pickup in the global economy. Unemployment should decline gradually, it said, while inflation is expected to accelerate to 2.2% by the end of 2020. It's an enviable mix. Yet against this favorable backdrop, such a deeply negative deposit rate—coupled with the SNB’s reiteration that it's willing to intervene in currency markets to weaken the franc if needed—seems out of place especially with Swiss policy makers still not even outlining a pathway to tighter policy. “I think that SNB runs the risk of falling behind the curve as the global economy is recovering,” said Stefan Gerlach, chief economist at EFG Bank and former deputy governor of Ireland’s central bank. It isn’t alone. Sweden and Denmark—which like Switzerland are outside the eurozone—also have negative policy rates despite healthy economies. Norway’s policy rate is just 0.5% but unlike the Swiss, its central bank on Thursday signaled that it may raise interest rates soon. Within the eurozone, Germany’s strong economy appears at odds with the -0.4% deposit rate and quantitative easing program that the ECB has installed for the euro area as a whole. The Federal Reserve has raised interest five times in two-plus years, but at a range of 1.25-1.5%, the Fed-funds rate is quite low. The SNB is constrained in raising interest rates by a trio of forces: the strong franc; low inflation; and the ECB. The euro fetched around 1.17 early Thursday. Though stronger than it was a year ago against the Swiss currency, the euro remains well below the 1.4 franc to 1.6 franc range before the eurozone’s debt crisis escalated in 2010. That has made Swiss products more expensive in Europe, the source of much of the country’s exports. Meanwhile, annual inflation was just 0.6% in February, well below rate in the U.S. and Europe. Unlike the Federal Reserve, European Central Bank and others, the SNB doesn’t target 2% inflation. It has a broader goal of keeping inflation under 2%, making it less necessary to respond to superlow inflation with easy-money policies. Still, with price pressures so low, the SNB has little to fear from an inflation standpoint by keeping rates negative. But there are other consequences, particularly on housing. The residential investment property sector “is subject to the risk of a price correction over the medium term” given its strong growth in recent years, the SNB said Thursday. Yet it's difficult for the Swiss to use interest rates to prick potential housing bubbles. Because Switzerland is a small, open economy highly dependent on Europe, the SNB is sensitive to policies taken by the ECB. As a result, many economists think the SNB will wait for the ECB to start raising rates before doing so itself, and the ECB has signaled it's no rush to increase its own negative deposit rate. The ECB is in the process of gradually scaling back its asset-purchase program. The SNB’s inaction “is far from a catastrophe, but it would be desirable to talk about how they’ll adjust policy,” said Mr. Gerlach.

Answer 1

Negative policy rates imply that citizens end up paying interests on credit balances. When depositors are charged money for keeping them in the bank, the authority is effectively discouraging saving and encouraging spending to boost the economy. The rationale behind the negative interest rate can be explained as follows:

• The global equilibrium interest rate has decreased over the years. Even the US Federal Fund Rate is very low, though not negative. Additionally, there has been mostly been expansionary monetary policy around the rest of the world to strengthen a weak economy. Switzerland is a very small open economy. This means that being small, it doesn’t have enough market power to affect rates, but being open, it does get affected by policies and rates of large open economies. The ripple effects faced by Switzerland would’ve been worse had it kept a high or positive interest rate when the rest of the world was going very low on interest rates.
• From the exchange rate point of view, without a negative interest rate, the Swiss franc would’ve appreciated, thereby shrinking exports, raising imports, generating a trade deficit, resulting in lower inflation and higher unemployment. It wouldn’t enjoy the low unemployment rate and trade surplus as has been reported. From the credit availability point of view, negative policy rates imply lowering of short and long term interest and market rates. Cost of borrowing falls tremendously and consumption/investment are raised which boosts the economy.
• Thirdly and most importantly, since Swiss has a floating exchange rate, when negative euro rates against the dollar were declared to be negative in 2014, the interest rate differential of Swiss franc and Euro also became negative. This put a downward pressure on Swiss Policy Rates, and with a negative rate of about -0.75%, the original interest rate differential was re-established and a lot of pressure was taken off the Swiss franc. Also extremely low real equilibrium exchange rates have contributed to negative policy rates. Being heavily dependent on the policies of ECB, unless ECB raises rates, there is no chance for SNB to do the same.

The author says that the Central Bank is still in crisis mode because despite a healthy looking economy, policy rates have been kept negative and deposits rates unchanged for three years. Swiss franc investments have become unattractive and there is a constant need for SNB to intervene and deliberately keep Swiss franc at very low values. The Swiss policy makers have not set a border for tightening the monetary policy. If not properly planned, the economy would slow down way too much while the rest of the world would be growing. After the euro zone debt crisis, Swiss products had become expensive in Europe (major source of Swiss exports) which has led to a fear of losing out on trade surplus because of reduced exports. Adding pressure to the financial and economic crisis is the real estate crisis through housing markets which keeps the crisis mode of Central Bank burning.

The low rate policy has adversely affected the housing market in Switzerland. Potential housing bubbles have developed and there is not much that negative rates can do to fight them. Housing bubbles imply an sharp rise in price due to soaring demands and then a sharp drop in housing prices when supply increase to match the soaring demands but demands become stagnant. Surplus in the housing markets result in steep drops and the bubble bursts. If not corrected at the proper time, bursting housing bubbles can result in the worst financial crises, making a small open economy plummet in no time. Since low interest rates directly result in high risk taking, investors must realize that real estate is a market falling under long term planning horizon. In an economy where mortgage rates were already unstable, the real estate market faces a host of potential threats that might result in a bad financial crisis.

The situation in Switzerland does suggest a potential conflict between internal and external balance in the Swiss Economy. While trying to maintain internal balance will mean price stability along with full employment, maintaining an external balance refers to maintaining just the right amount of deficit/surplus. With negative rates and a depreciating Swiss franc value, external balance can be maintained through the correct amount of surplus however, since low rates encourage spending and increase liquidity in the economy, there are chances of high inflation which will make the internal economy go out of balance by failing to maintain price stability. Thus there is a potential conflict between internal and external balance of the economy.