Monetary policy report 2004

Initial situation: quarterly assessment of 12 December 2003

Four times a year – in March, June, September and December – the National Bank’s Governing Board conducts a regular assessment of the monetary policy situation. Each of these assessments results in an interest rate decision. In certain situations, interest rate changes are also effected between the regular assessments. In the past year, however, this was not the case.

At the quarterly assessment in December 2003, the National Bank assumed that the Swiss economy would see increasingly broad-based growth of 1.5-2% in 2004. On the assumption that the three-month Libor would remain constant at 0.25% for the next three years, it forecast annual average inflation rates of 0.4% for 2004, 1.0% for 2005 and 2.3% for 2006. While pointing out that the economic upswing was not yet a fact, the Governing Board left the target range for the three-month Libor unchanged at 0.0-0.75%, with a targeted rate of 0.25%. As the closure of the output gap, which had been negative since mid-2001, approached, however, inflationary pressure was expected to increase as of mid-2005. It became clear that the extremely expansionary monetary policy pursued in the preceding two years would have to be gradually corrected. For the time being, however, the interest rate range was left unchanged.

Graph Three-month Libor, Quarterly assessment in December 2003

Quarterly assessment of 18 March 2004

At the March 2004 assessment, it was confirmed that the economic upswing had gained momentum during the winter. While the data pointed to strong growth in the US, the recovery in Europe was still fraught with uncertainties. The financial markets, too, remained sceptical about the upswing’s sustainability, as was evidenced by their expectations of an unchanged monetary policy.

The inflation forecast issued in March largely corresponded to the December 2003 forecast. Based on the assumption that the three-month Libor would remain at 0.25% for the next three years, the 2004 inflation rate was put at less than 0.5% (disregarding minor fluctuations due to baseline effects). From the beginning of 2005 onwards, expansionary monetary policy coupled with the predicted closure of the output gap resulted in considerable dynamism in the price trend. The forecast for mid-2005 reached 1% and that for mid-2006 went up to 2%, rising to 3% towards the end of 2006. Consequently, it had to be expected that an unchanged monetary policy would result in a breach of price stability.

The outlook for the economic upswing in Switzerland had improved, and an imminent closure of the output gap was expected. Moreover, the economy’s liquidity overhang had widened again. As a result, the forecast rise in the inflation trend had been brought forward. Even so, the time did not yet appear ripe for an adjustment of monetary policy: the economic recovery at home and abroad was still too shaky. It was important not to jeopardise the upswing in Switzerland with an over-hasty changeover to a more restrictive monetary policy. If the National Bank had raised interest rates at this point, the Swiss franc would have come under upward pressure. The Governing Board thus decided to retain the strongly expansionary monetary policy. It left the target range for the three-month Libor at 0.0-0.75% (a level that had remained unchanged since 6 March 2003), and targeted a rate of 0.25%. In doing so, however, the National Bank indicated that it would not be able to continue its highly expansionary policy indefinitely without endangering price stability. It thus announced that it would have to adjust its policy as soon as the economic upswing was clearly confirmed.

Graph Inflation forecast Q1 2004

Quarterly assessment of 17 June 2004

At the June assessment, it was found that the prospects of a sustained improvement in the business climate had become more tangible. The National Bank was still expecting GDP to grow by 1.5-2%, but was now looking at the upper end of this range. The factors which it had cited as a reason for adhering to an unchanged monetary policy stance in March had changed. The world economy appeared considerably more robust. In the US, the upswing was now underpinned by a brisker labour market and a marked improvement in order intake. The economic situation was improving in Europe, too. In Switzerland, a retrospective assessment of the economic situation looked more positive following the revision of statistical data, which indicated that the upswing had already been in progress for a year. Moreover, leading economic indicators suggested that growth would accelerate in the second half of 2004. The historically low interest rate levels and the continuing growth in the money supply mirrored a highly expansionary monetary policy stance. The financial markets were anticipating a rise in the three-month Libor by 25 basis points. The absence of any change in bond yields at the long end of the market implied that long-term inflation expectations had remained unchanged. Meanwhile, yields on short to medium-term debt securities rose. The anticipation of a rate increase reflected in these yields substantially boosted the Swiss franc against the euro prior to the quarterly assessment scheduled for June.

As both the Swiss and international economies developed in line with the expectations voiced at the March 2004 assessment, the inflation outlook was practically identical with that of the previous quarter, both for the medium and long term. Compared with March, the time at which expansionary monetary policy would start to have marked effects on inflation had been brought forward again: less than a year remained until the reversal of the inflation trend. Given this background, the Governing Board decided on 17 June 2004 to raise the interest rate target range by 0.25 percentage points to 0.0-1.0% and to keep the three-month Libor in the middle of this range (i.e. around 0.5%) until further notice.

The new inflation forecast, which was based on a steady three-month Libor of 0.5%, showed a slightly higher inflation rate in the near term, due mainly to the unexpectedly sharp rise in prices of oil products. From mid-2005 onwards, the analysis revealed an acceleration of future inflation owing to the anticipated closure of the output gap and the excessive supply of liquidity. Towards the middle of 2006, the predicted annual inflation rate exceeded the 2% price stability threshold, easily topping 3% by the end of the forecasting horizon.

Graph Inflation forecast Q2 2004

Quarterly assessment of 16 September 2004

The US economic data incorporated into the September assessment had worsened slightly during the summer. In Europe, the trend appeared to be steadier. Germany and France, the two largest economies, were expanding after having slowed down growth in the euro area in 2003. The Swiss economy, too, continued to recover – albeit at a rather slower pace than before. The oil price remained on its previous steep upward trajectory, and annual inflation rose to approximately 1%. As in the lead-up to the June assessment, the three-month Libor showed signs of rising beyond the mid-point in the target range towards the end of August. The financial markets were evidently expecting the September assessment to result in an interest rate hike. The Swiss franc weakened against the euro, even though the June increase in interest rates had narrowed the spread versus the higher yields on euro investments. Other indicators confirmed the impression that monetary policy was highly expansionary. In particular, real short-term interest rates were still negative despite the raising of the target range, and the monetary aggregates still pointed to an ample liquidity supply.

The September analysis of the inflation outlook resulted in two changes from the June outlook. Up to mid-2005, forecast inflation was above the June figure due to the rise in the price of oil. In the longer term, slightly lower inflation potential was expected – this was ascribed to a reduction in the liquidity overhang. The medium-term inflation outlook was the same as in the previous quarters, reflecting the fact that the economic development had not changed. On the whole, the analysis of inflation prospects pointed to a rising inflation trend towards the end of 2005, leading to a permanent overshooting of the 2% mark in the course of 2006.

Despite the mild slowdown in business activity and the slight easing of longer-term inflationary pressure by comparison with the previous quarter’s predictions, monetary policy was still too expansionary. In light of the longer-term inflation forecast, the Governing Board decided at its assessment on 16 September 2004 to raise the target range for the three-month Libor by a further 0.25 percentage points to 0.25-1.25%. A three-month rate in the middle of this band (i.e. approximately 0.75%) was targeted. This second interest rate increase in 2004 confirmed the National Bank’s basic confidence in a continuation of Switzerland’s economic upswing. Even after this second interest rate adjustment, the three-month Libor was low by historical standards, a sign of a clearly expansionary monetary policy.

Graph Inflation forecast Q3 2004

Quarterly assessment of 16 December 2004

Global economic growth had decelerated slightly since mid-2004. While this was due in particular to the surge in oil prices, the economic slowdown in Asia was also a contributing factor. In the EU, the weakening of the dollar created an additional burden. In the US, by contrast, economic growth remained sound. According to National Bank’s estimates, Swiss GDP grew by close to 2% on average in 2004. The SNB assumed that the economic upswing would continue in 2005. Given the slightly dimmer outlook for the global economy, however, it was thought that the upswing was unlikely to strengthen further, with real GDP growth put at around 1.5-2%. The price of oil (Brent crude) reached a peak of USD 52 at the end of October. Under the impact of the higher oil prices, the annual inflation rate rose up to 1.5% in November. However, the last assessment of 2004 was dominated less by oil prices than by the heavily weakened US dollar. Between mid-October, when the dollar’s decline accelerated, and mid-December, the US currency had lost 8% against the Swiss franc. In November, the real appreciation of the Swiss franc against the currencies of Switzerland’s 24 most important export markets – essentially North America and Europe – came to 2.5% year-on-year. This real appreciation against the currencies of Switzerland’s key trading partners, which was more modest than the Swiss franc’s nominal appreciation against the dollar, was attributable not only to Switzerland’s lower inflation rates but also to the stable relationship between the euro and the franc. Overall, the real appreciation of the Swiss franc resulted in a more restrictive monetary environment, which had a dampening effect on inflation.

Based on an unchanged three-month Libor of 0.75%, December’s inflation forecast featured three changes compared with the September forecast. Firstly, it forecast higher inflation in 2005. This reflected the renewed upsurge in the cost of oil products. Secondly, it predicted a weaker rise in inflation in 2006. The reason was the later-than-expected closure of the output gap owing to an anticipated cyclical slowdown. Finally, lower inflationary pressure was also predicted over the longer term. This was due to the continuing reduction in the liquidity surplus, which had begun last summer.

A combination of the slowdown in growth momentum, the marked weakening of the dollar and the decline in surplus liquidity had led to a reduction in the anticipated inflationary pressure, thus reducing the need for a further rise in interest rates. The Governing Board therefore decided to leave the target range for the three-month Libor unchanged at 0.25-1.25% and to keep the three-month rate in the middle of this range at 0.75%. Consequently, monetary policy remained expansionary. However, the SNB pointed out that the interest rate normalisation phase begun in June was not yet over, considering that the forecast predicted a rise in inflation over the medium term.

Graph Inflation forecast Q4 2004

Monetary policy challenges in 2004

The interest rate decisions taken at last year’s quarterly assessments reflect the conflicting demands impinging on monetary policy. On the one hand, monetary policy was highly expansionary by historical standards – despite the interest rate rises implemented. On the other hand, various imponderables complicated monetary policy decisions. While the March assessment was overshadowed by uncertainty over the sustainability of the economic recovery, the rise in oil prices led to an increasing risk of a deterioration in the domestic and international economic outlook. In the autumn, the sharp depreciation of the dollar made the assessment of the economic situation even more difficult.

Rise in oil prices as particular problem

One of the crucial issues affecting monetary policy in 2004 was the substantial rise in oil prices, which began last spring. The National Bank’s June inflation forecast was still based on the premise that oil prices would ease in the near term. In its September forecast, the SNB was still assuming that oil prices would soon fall, albeit not to the level prior to the increase. Whereas the two interest rate hikes in June and September were motivated by the state of the economy and the excessive money supply, the sharp rise in oil prices – which increased inflationary pressure in the near term – did not prompt an interest rate move. There were three reasons to refrain from interest rate adjustments in response to firming oil prices. Firstly, it would be wrong to try to stabilise oil-price-related fluctuations in the price level by raising interest rates. Experience has shown that a monetary policy which seeks – by way of interest rate increases – to prevent oil price rises from having an impact on the price level can significantly reinforce the adverse effect of such rises on the economy. Secondly, any attempt to compensate for an oil-price-related economic slowdown by cutting interest rates would be misguided. It would merely increase the risk of a wage-price spiral. The greater the already existing liquidity surplus, the greater the likelihood of such second-round effects. Thirdly, the National Bank’s assumption that the higher oil prices were short-lived suggested that any inflationary impact of these prices would gradually recede of its own accord.

Monetary policy torn between short and long-term needs

In retrospect, monetary policy in 2004 was shaped by the contrasting implications of short and long-term views. While the long-term perspective made a tightening of monetary policy appear desirable, uncertainties over the future course of the economy militated more in favour of a relaxed pace. The monetary policy stance adopted by the National Bank in 2004 was the result of having to strike a balance between these two considerations. On the one hand, the SNB’s interest rate decisions continued a very relaxed monetary policy that was designed to support the economy. On the other hand, however, they were the first steps towards a normalisation of the interest rate level.