- Date:
- Author:
- Stefan Gerlach
Infocus - Inflation has surged to levels not seen in decades due to rising commodity prices, supply chain bottlenecks and tight labour markets. These factors apply to most developed countries, but not to Switzerland where inflation remains low. In this edition of Infocus, GianLuigi Mandruzzato compares Swiss inflation to that in the US and the eurozone and draws some policy implications.
A little more than two years have passed since the Swiss National Bank (SNB) started to raise interest rates after having kept them at -0.75% for seven years. Since then, it has raised interest rates five times by a cumulative 2% and cut them twice by 0.5% in total. In this InFocus article, EFG Chief economist Stefan Gerlach looks at SNB policy over this period to understand better how the SNB will set rates in the future.
Between 2015 and 2022, the SNB held interest rates constant at -0.75%. Since then, it has raised interest rates five times by a cumulative 2% and cut them twice by 0.5% in total. What can we learn about SNB interest setting during this period? What does it suggest the SNB will decide in September?
One view is that this is too little data from which to draw firm conclusions and that it would be better to look at a longer period. However, data from before 2015 are likely to be unrepresentative since the neutral real interest rate, r*, is often said to have declined over time.1
An alternative view is this short data sample can be used, but that we must be modest in our aspirations in learning from it. This is the view we take here. Our objective is to develop a starting point for thinking about SNB policy. As time passes and more data become available, the model can be updated and refined.
Inflation and the SNB’s policy rate
Figure 1 shows data on the SNB’s policy rate and inflation from 2018 to June 2024. As noted above, at the start of this period, the policy rate was at -0.75% – a world record low. Inflation was also low, dipping below zero in 2019 and turning solidly negative after the onset of Covid in early 2020. From early 2021 inflation rose and peaked above 3% in early 2022. It has since subsided and is now well within the SNB’s 0-2% definition of price stability (or target).
In response to the swings in inflation, in June 2022 the SNB initiated a series of interest rate increases that took rates to 1.75% by June 2023. As inflation started to decline, it then held rates constant until March 2024, when it cut rates amid growing evidence that price pressures were abating. It cut rates again in June 2024.
A reaction function for the SNB
To analyse central bank interest rate setting, economists often make use of the Taylor rule, which was developed to capture the Federal Reserve’s interest rate policy in the late 1980s and early 1990s. According to the Taylor Rule, the interest rate the Fed sets is equal to:
➡ the neutral real interest rate, r*, (assumed to be 2%), plus
➡ the rate of inflation, plus
➡ ½ of the deviation of inflation from a 2% target, plus
➡ ½ of the deviation of the output gap from zero.
This implies that interest rates rise by 1.5 times the increase in inflation and 0.5 times the increase in the output gap.
This is the starting point for the analysis. However, there is no reason for the SNB to behave in the same way so instead of using the assumptions of the Taylor rule, the parameters are best fitted to the Swiss data using statistical techniques.
That exercise yields the following conclusions:
➡ The neutral interest rate, r*, was minus one percent in Switzerland in the period studied.
➡ The real interest rate – defined as the policy rate set at the last meeting minus the rate of inflation – influences the SNB’s interest rate setting. The SNB cuts rates when the real interest rate is too high and raises them when it is too low.
➡ The SNB is more likely to raise interest rates if it raised them at the last policy meeting and vice versa.
➡ The SNB did not appear to change interest rates in response to a weaking of economic activity, as captured by sentiment indicators. (In a period in which the focus of policy was squarely on lowering inflation, which is helped by inducing some economic weakness, that is unsurprising.)
To explore the fit of the model, Figure 2 shows on the horizontal axis the predicted change in the interest rate at each policy meeting and on the vertical axis the actual change. If the model did a perfect job accounting for the SNB’s interest rate changes, the data would all fall on a line with a 45-degree angle; dispersion around the line captures the model’s explanatory power.
Given the simplicity of the model and the fact that it does not incorporate the exchange rate, it is striking how well it accounts for the SNB’s interest rate changes over this period.2 To see that formally, the correlation between the two series is 0.92.
The SNB’s policy decisions
But the SNB changes interest rates in multiples of 0.25% and not in basis points. Figure 3 shows the fitted values rounded to the closest 0.25% and the actual interest rate change adopted by the SNB.
It predicts an interest rate increase two quarters before it occurred. (However, the SNB caught up by raising interest rates by 50 bps at the third meeting whereas the model predicted merely a 25 bps increase; and at the fourth meeting when the SNB raised rates by 75 bps while the model predicted a 50 bps increase.) Similarly, it predicted an interest rate cut a quarter before it occurred.
The finding that the SNB changes interest rates with some lag after the model reflects the fact that the analysis uses data for the full period whereas the SNB only had data until the time of its decisions. Had it known how inflation would evolve, it would have no doubt raised, and cut, rates earlier.
The September meeting
With the next SNB policy decision on 26 September, it is of interest to see what change in the policy rate the model predicts.
Figure 4 overleaf shows the predicted change in the policy rate for various inflation rates and assumptions regarding r*. The upper panel presents results in terms of basis points; in the lower panel they have been rounded to the nearest 25 bps, since that is presumably the smallest interest rate step the SNB will consider taking.
The far left column considers the case of r* = -1%. Recent inflation rates have been in the range 1.3% to 1.6%. If inflation stays at this level, the model predicts a cut of 25 bps.
However, out-going SNB chairman Jordan pointed out in a recent speech that the SNB thinks that r* has risen to 0%. If so, the column on the far right of Figure 4 applies. Interestingly, in this case, the SNB will only cut rates if inflation is below 1.4%.
It is clear from this analysis that the key question the SNB faces in September is whether to cut interest rates by 25 bps or leave them unchanged, and that choice depends crucially on its views of r*.3
While many commentators would have drawn those conclusions without a model, this model has the advantage that it offers a formal way to see how policy choices depend on inflation and r*. Thus, it is possible to assess what the SNB may do with rates for a variety of inflation rates and assumptions about the neutral real interest rate.
Conclusion
This analysis shows that a simple model which considers the SNB’s previous quarter’s interest rate decision, the rate of inflation, and which assumes an equilibrium real interest rate of minus one percent does a good job accounting for the SNB’s interest changes over the 2021-24 period.
While the model suggests that the SNB is likely to cut interest rates in September, the key factor appears to be the SNB’s view of the neutral real interest rate, which is unobserved.
Looking ahead, one would expect the model may underpredict the SNB’s policy rate as SNB Chairman Jordan has indicated that the SNB now believes that r* has risen to zero. Time will tell.
1 The neutral real interest rate is that that would ensue when inflation is at target and the output is at potential.
2 One can think of three explanations for strong predictive power of the model, despite its omission of the exchange rate. The first is that exchange rate changes impact on inflation, which the SNB does respond to. The second is that exchange rate changes trigger exchange rate intervention rather than interest rate changes. The third is that commentators may have exaggerated the importance of the exchange rate for SNB interest rate policy. To see whether that is the case, direct estimates of this effect are necessary.
3 It is striking how little the choice of interest rate is affected by changes in r*. While that may be surprising, the graph only shows the responses for a single – the next – policy meeting. Over time as the full adjustment is carried out, changes in r* will lead to proportional changes in the nominal interest rate set by the SNB.
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