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.