SNB wary of inflation amid seismic FX policy shifts

The SNB lifted rates at its last policy meeting, undeterred by the uncertainty plaguing the banking sector and resolutely focusing on inflation. We explore recent monetary policy developments, including profound changes in how the central bank regards and communicates on foreign currency interventions.

An exceptional week for the SNB

It was a remarkable last week for the Swiss National Bank (SNB), beginning with the orchestration of the UBS and Credit Suisse merger and ending with a 50bps rate hike. While arguments for a slowdown in rate rises might have arguably emanated from concerns about financial stability and volatility in financial markets, it appears instead that the SNB focused on the renewed acceleration of domestic inflation necessitating tighter financing conditions.  

Events surrounding UBS and Credit Suisse exert enormous influence of the whole of Switzerland, where banking accounts for a large share of the economy. As of 2021, some 107,500 people were employed at banking institutions in Switzerland. The financial sector (including insurers) accounted for 9.0% of GDP in 2021. While the UBS/CS resolution had its intended effect, going forward, we will be following the impact on the Swiss economy and that of greater uncertainty globally in the banking sector.

More immediately, our focus has been on developments in inflation and foreign exchange interventions, and the next steps for Swiss monetary policy.

Inflation turns domestic

Rather than taking a more cautious approach, the SNB’s rate increase clearly signalled that it continues to act to counter the aggressive rise in inflation this year. At 3.4%, inflation is clearly above the below 2% target that the SNB equates with price stability. The central bank singled out higher prices in electricity, tourism services and food. While much of such firming could be looked through, it does suggest second round effects appear to be concerning the SNB.

Individual components of inflation show that the upswing has been more broad-based and domestically driven. Trimmed CPI, which excludes the 15% in the CPI basket with the highest and lowest rate of change, has continued to rise and make new highs (figure 1). Trimmed CPI reacts less to outliers and can be taken as a signal that a larger part of the basket is moving.

Figure 1. Inflation indices for Switzerland

Source: Federal Statistics Office of Switzerland, SNB, LOIM calculations. As of Feb 2023.

Meanwhile, headline domestic inflation has clearly increased, compared to rises last year that were driven by imported inflation (figure 2). Currency fluctuations drive imported changes to a large extent. But domestically, hotel prices have also gone up, for instance, due to second round effects.

Figure 2. Swiss domestic vs imported inflation

Source: Federal Statistics Office of Switzerland, LOIM calculations. As of Feb 2023.

Seismic firsts in FX interventions

While other global central banks undertake quantitative tightening via the bond markets, the SNB is unique in using the foreign exchange (FX) markets. SNB President Thomas Jordan told the press conference that the SNB sold CHF27bn worth of foreign currency in Q4 and will continue to sell foreign currency in the future, if appropriate from a monetary policy perspective. This marked the first time the bank has quantified its Swiss franc buying in currency markets.

FX interventions have been a key plank for SNB policy for years, but they were never explicitly included in the bank’s toolkit. That all changed last year when, after quietly conducting a comprehensive review of its monetary policy, the SNB changed how it implements policy.

The central bank’s annual report added an explicit provision to “also use additional monetary policy measures to influence the exchange rate or the interest rate level, if necessary. With this adjustment, the SNB is taking into account the increased importance of such measures in recent years.”

This is a seismic change. Until now, measures such as currency interventions were deemed unconventional. Now, the SNB has added the ability to use the exchange rate as a longer-term conventional policy tool.

How this plays out matters: unwinding CHF27bn of the SNB’s CHF885bn balance sheet may seem relatively small, but it was accompanied by little material appreciation of the Swiss franc, helped dampen imported inflation and bodes well for future sales of foreign currency holdings. The expansion of the toolbox gives the SNB the discretion sell more foreign currency over the long-term, in the background, without having to justify its actions. It also removes any urgency for action and allows it to sell (and buy) flexibly, avoiding possible political pressures. We see these developments as positive for a smooth (eventual) shrinking of the balance sheet.

Another hike vs SNB predictions

We expect the SNB to hike again in June, even if the bank’s inflation predictions tell a different story.

The SNB’s latest set of conditional inflation forecasts seems to suggest that several more hikes could be needed because the forecast does not show inflation ever falling below the 2% policy target (figure 3). This sends an extremely strong signal that current policy will still not manage to return inflation below target and could require additional rises. Keeping open the possibility of several hikes could also signal the SNB believes the currency needs to do more to soften inflation.

Figure 3. SNB conditional inflation forecasts

Source: SNB, LOIM calculations. As of March 2023.

Going forward, our expectation is that inflation will decelerate in the medium term and that the global outlook and financial stability present on-going risks to the economy. While the resolution of Credit Suisse has been addressed for now, the nature of demands on banks has changed materially with the advent of digitalisation. This can lead to greater pressures on bank liquidity at a much faster pace, leading to profound repercussions for individual banks. Yet it also coincides with improved general stability for the banking system as a whole: the risk of contagion has diminished markedly since the 2008 financial crisis due to banks being better capitalised and holding greater buffers.

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