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Ending Swiss Fixed Exchange Rate Is a Welcome Step

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Ending Swiss Fixed Exchange Rate Is a Welcome Step

January 22, 2015

In what was possibly the most significant currency move since the end of the Bretton Woods system in 1971, the Swiss National Bank (SNB) has ended its cap on the Swiss franc exchange rate with the euro, which effectively sent the Swiss franc soaring against the euro to as high as 30 percent in intraday trading, marking the largest intraday gain since 1971. The Danish National Bank may also be reconsidering its fixed exchange rate with the euro as well.

While there is fair criticism over how the SNB communicated the policy move, removing the cap on the franc is a win for believers in floating currencies. Caps on exchange rates are anti-competitive regardless of whether they are imposed in China, a communist country, or Switzerland, a well-known tax haven. Such currency caps attempt to keep a country’s own currency artificially undervalued to boost domestic exports at the expense of making another country’s currency overvalued and exports more costly and unattractive. 

In the case of the SNB, the cap was used to keep the value of the franc low relative to the euro, with the aim of boosting Swiss exports at the cost of making Eurozone exports less attractive.

Keeping an exchange rate capped comes at another serious cost: price instability. Purchasing power parity dictates that prices in one country should match prices in another country, when adjusting for the exchange rate conversion (net of transaction and shipping costs).

In a floating currency market, the exchange rate will normally adjust to satisfy this relation. However, when currencies are pegged like in Switzerland or China, prices will be adjusted instead to satisfy purchasing power parity. This creates the potential for volatile inflation.

In the past ten years for example, China has seen its annualized year-over-year inflation rate move above 8 percent in response to its cap on the yuan against the U.S. dollar.

One argument against lifting the cap on the Swiss franc against the euro is that Switzerland wants to avoid further deflation and slowed economic activity in response to an appreciating exchange rate. 

One significant point is that not all inflation (or deflation) is created equal. There is an important difference between deflation caused by a short-fall in “aggregate demand” such as the deflation observed during the Great Recession that was coupled with a significant decline in real GDP, and deflation caused by a positive shock in “aggregate supply” from the fall in oil prices which may be accompanied with positive economic growth. 

Federal Reserve Chairwoman Janet Yellen has said that the falling price of oil “will likely hold down overall inflation in the near term” and that “the decline we've seen in oil prices is likely to be, on net, a positive" for economic growth.

Indeed, as year-over-year core PCE inflation has recently fallen to 1.3 percent in the United States and 0.5 percent in the U.K., both the United States and U.K. have witnessed their unemployment rates fall well below 6 percent.

This is not to be confused with the deflation of the Eurozone which may be more of a result of falling “aggregate demand” as a result of the continuing European sovereign debt dilemma. U.K. Chancellor of the Exchequer George Osborne has explicitly made this distinction in talking about oil-driven U.K. deflation, saying that “we should not confuse this welcome news with the threat of damaging deflation that we see in the Eurozone.”

In Milton Friedman’s classic 1967 address to the American Economic Association entitled, “The Role of Monetary Policy,” he outlined the problems of not having a floating currency, including wildly varying inflation rates. In making his argument, Friedman cited the volatile inflation rates of countries within the 20th century Bretton Woods system of fixed exchange rates and fixed gold convertibility rates for currencies.

While Switzerland has begun to observe some deflation, Switzerland did not see the same sort of economic downturn and price level decline as the rest of the OECD in 2008. The Swiss economy has long since fully recovered from its downturn, now boasting GDP that is 8 percent above its pre-recession level and an unemployment rate of 3.5 percent. This makes Switzerland one of the last countries that should feel the need to keep its currency artificially-low relative to a wavering currency bloc such as the Eurozone.

The SNB hedged their decision to scrap the currency cap by simultaneously introducing negative interest rates on overnight bank deposits. Its goal is to stop the rush to sell euros and buy Swiss francs through making interest rates in Switzerland less attractive than European interest rates. 

The European Central Bank has been soon to follow in reducing in beginning rounds of quantitative easing, in an attempt to expand its balance sheet to 3 trillion euros. Some argue that the move by the SNB was deliberately done ahead of the ECB’s QE announcement that could have made the effort to keep the euro capped at 1.20 francs untenable, as increasingly more SNB foreign exchange reserves would be required to sustain the capped exchange rate. Indeed, the size of the SNB’s balance sheet already sits above 80 percent of Switzerland’s GDP, well above any other developed country.


Source: PIMCO


While there are many critics of the effectiveness of proposed ECB quantitative easing and continued loose monetary policy from both the ECB and SNB, the current policy regime is a positive shift from the remnants of 20th century currency caps, which hindered floating currency markets and price stability. 

It is a fair argument that the SNB could have better communicated its decision to drop the cap on the Swiss franc. Completely reversing SNB communications from as recent as December that the central bank had the “utmost determination" to keep the cap certainly contributed to some of the subsequent turmoil in the market and perhaps damaged the SNB’s credibility.

Notwithstanding, eliminating the outdated monetary policy tool in place since 2011 was an important step. The Swiss should be proud of this positive change in their monetary policy.


Jon Hartley is a Forbes economics contributor and the co-founder of Real Time Macroeconomics LLC, a financial-technology firm. He is also on the advisory board of the Manhattan Institute’s Young Leaders Circle. You can follow him on Twitter here

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