Wednesday, May 30, 2012

The Power of Promises

A bonus post for today.

Switzerland's central bank, the SNB, got a whole lot of attention when it intervened in currency markets in the summer of 2011. The swiss franc (CHF) had appreciated rapidly, and with year-over-year headline inflation near zero, the central bank took up arms to defend its monetary policy goal of price stability.

The SNB made a bold surprise promise: we will not let the swiss franc appreciate any more; we will hold the exchange rate at 1.2 CHF to 1 euro. And, in short, it worked. The appreciation of the swiss franc came to an immediate halt. The CHF-EUR exchange rate stabilized at 1.2. Even during this current turmoil in the Eurozone -- which one might think would lead the currency to appreciate as capital flowed into Switzerland's financial safe haven assets -- the Swiss central bank has kept the exchange rate steady, fulfilling its promise.Switzerland has the ability to stabilize its currency from upward pressure because its monetary policy tool is unlimited -- it could always print out more swiss franc to satisfy market demand. This is, in other words, the opposite of trying to prop up a currency, which strains the foreign currency reserves of the central bank. The result is that the Swiss intervention is entirely credible.

Its credibility is so powerful, in fact, that the SNB has stopped having to buy up foreign currencies with new swiss franc, which it did in earnest to prove its commitment in 2011, increasing its foreign exchange reserves by 177 billion from July to September. It hasn't had to defend at all the value of its currency against appreciation since September, despite what should be enormous pressures. (See here and here for the data.) That is truly remarkable, when you zoom out for the macroeconomic big picture.

That is the power of credible monetary promises. And we can do the same thing with the price level path, of course, managing correctly the striking strength of market expectations. All it takes is the appropriate use of the expectational channel; re-establish 5 percent annual NGDP growth as did the SNB for its currency, and then the market will do the rest for you.


  1. I do strongly believe in NGDP targeting and am a proponent of introducing it by local central bank.
    I, however, can't appreciate rather simplistic view of yours: practically, NGDP and exchange rate targeting are slightly different. Thus, the Switzerland case just can't be a sound argument.

    First, I should express my concerns about your current narrative: do the central bank posess the ability to control the exchange rate? Increasing the foreign investments by 60% is possible; is that true for the same amount of negative stimulus?

    Second, even if it is (it is! historically, central bank can peg the exchange rate)... does the existense of exchange rate targeting prove the ability to target NGDP?
    That's the hard question.
    The mechanism of exchange rate targeting is the simplest possible: CB just trades any currency amounts given the fixed price; the only needed stimulus is implemented through the currency market and its amount is decided automatically.
    The transmission mechanism of NGDP targeting is much more complex and involves slightly arbitrary matters like animal spirits and expectations... could it work?
    I'd like it to.

  2. Yes of course it would work. The central bank just uses the same mechanisms as now, interest rates and Q.E. The methods don't change, but NGDP and NGDP expectation (a futures market) are more suitable measure of response to policy than employment or price level changes. See

  3. The methods don't change; heck, the methods are just a matter of choice. They would work as usual.
    The problem is not the policy-target part of mechanism; my opinion is the feedback imposes more problems. One can't question the Fed's ability to manipulate NGDP. Can, however, Fed target the specific NGDP level successfully?
    It's obvious for me that expectations mechanism can't be effective during the first periods of NGDPt: is confidence in Fed's policy currently present? (moreover, I don't think expectations to be such a precise tool)

  4. NGDP is an optimal target. An example is the past 3 years. NGDP growth is slow, primarily due to unemployment in construction. We need monetary stimulus. But targeting price levels delays more aggressive stimulus because real estate weakness is not reflected in owner equivalent rents, the residential price parameter. NGDP is a much better measure of stable money than the complicated and arbitrary methods used now of adjusting for technologic change and consumer preference change. When a PC is twice as powerful at the same price, has the price dropped in half? Or is it unchanged because the new software needs more powerful hardware? All arbitrary. The fed should target NGDP.