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Wednesday, September 14, 2011

Swiss Decision: Exchange Rate Stability or Inflation Rate Stability

Swiss central bank President Philipp Hildebrand’s pledge to protect the economy with unlimited currency purchases may come at a higher cost than billions of francs: faster inflation.

Hildebrand’s decision risks flooding the financial system with cash and undermining the Swiss National Bank’s job of delivering price stability, said economists at Credit Suisse Group AG and Barclays Capital.

While central banks around the globe are seeking to ward off a recession through additional stimulus or rate cuts, the franc’s ascent forced Swiss policy makers into measures that sparked a decade of surging inflation when last introduced in the 1970s.

“You can’t have your cake and eat it,” said Claude Maurer, an economist at Credit Suisse in Zurich. “You can either pursue a ceiling on the exchange rate or you can fight price pressures. The SNB apparently sees medium-term inflation threats as the lesser of two evils.”

The Zurich-based central bank said on Sept. 6 it would purchase “unlimited quantities” of foreign currencies to defend a franc ceiling of 1.20 versus the euro “with the utmost determination.” The currency had previously appreciated 13 percent against the euro this year to a record 1.0075 on Aug. 9, chocking exports such as of Swatch Group AG watches.

Alexandre Ziegler, an assistant professor of finance at the University of Zurich, said inflation will breach the SNB’s 2 percent limit within the next three years even if the economy fails to grow. Consumer prices rose 0.2 percent in August from a year ago.

‘Inflation Potential’

The Swiss currency had been pushed higher on investor concern that European governments may be unable to contain the region’s debt crisis and prevent Greece from defaulting. It has remained above 1.20 versus the euro since the SNB imposed the cap, trading at 1.2037 at 11:30 a.m. in Zurich today.

The SNB is creating an extremely high inflation potential,” said Thorsten Polleit, an economist at Barclays Capital in Frankfurt. “They create money and those obtaining these newly created funds will spend at least part of it on real estate, shares, bonds and consumer goods.”

To defend their ceiling, the SNB is taking on the $4 trillion-a-day foreign-exchange market. Before imposing the cap, the central bank’s foreign-currency holdings jumped to a record 253.4 billion francs ($305.1 billion) at the end of August, partly on foreign-exchange swaps to weaken the franc. That’s about half of Swiss gross domestic product.

Memories of 1978

The ceiling “is credible as long as the authorities are prepared to accept the liquidity implications of this potentially very large intervention,” said Dirk Schumacher and Adrian Paul, economists at Goldman Sachs Group Inc., in an e- mailed note. The policy “can potentially be maintained until inflationary pressures materialize.”

When used in 1978 to stem franc gains against the Deutsche mark, Swiss inflation breached the central bank’s ceiling in 12 of the following 20 years. Annual price growth reached 7.5 percent by mid-1981 after averaging 1 percent in 1978.

Juerg Iseli, 62, who experienced that time as chief executive officer of Swiss components maker Micronor AG, said it was a “difficult” period with some companies having “big problems” as a result of the SNB’s intervention policy.
“First the strong franc and then inflation,” Iseli said in a telephone interview. “Companies lost competitiveness because rising inflation forced them to increase prices.”

‘Challenging Journey’

The SNB also risks paving the way for a real-estate bubble as seen in the 1980s, according to Ziegler. In the four years after the central bank last introduced a currency cap, costs of rental apartments jumped 52 percent, with prices of single- family homes surging 37 percent, he said.

Swiss lawmakers, during a debate in Bern today, signaled concern that the SNB’s currency policy may boost price threats.

“I don’t want the country to face inflation rates last seen in the 1980s,” said Maximilian Reimann, a member of the upper house of parliament. “I’m not pessimistic by nature but the worst case can’t be totally excluded. The dangerous inflation vulture is already circling.”

The SNB already started flooding money markets with liquidity when cutting borrowing costs to zero last month. Swiss banks’ so-called sight deposits, an indication of potential future bank lending, ballooned to 187.7 billion francs on Sept. 9, up more than six times from Aug. 5.

Hildebrand has said that policy makers have started “a challenging journey” with possible “very high” costs.

Franc Action

“The SNB has made a conscious decision,” said David Kohl, deputy chief economist at Julius Baer Group in Frankfurt. “They are putting more emphasis on the exchange rate than on inflation.”

Hildebrand, 48, has been trying to get the franc under control since taking the SNB’s helm last year, while seeking ways to maintain price stability. A 15-month campaign to sell the franc was abandoned in June 2010 after price threats mounted along with accelerating economic growth.

Now, a cooling economy and inflation near zero are giving policy makers room to boost liquidity.
“The SNB has launched the ultimate weapon,” said Alexander Koch, an economist at UniCredit Group in Munich. “The subdued inflation outlook currently leaves the door wide open for massive monetary expansion.

Swiss Slowdown

The franc’s ascent has hurt some of the country’s largest companies. Holcim AG, the world’s second-biggest cement maker, said on Aug. 18 that currency effects shaved 203 million francs off operating profit in the second quarter. A slump in exports was the main reason why Swiss economic growth slowed to 0.4 percent in the second quarter, the weakest since the economy emerged from a recession in 2009.

The SNB will publish its latest economic projections tomorrow, when policy makers meet for their quarterly rate assessment. The central bank will probably keep borrowing costs at zero, according to all 21 economists in a Bloomberg News survey. It will announce its decision at 9:30 a.m. in Zurich.

While the SNB’s toolbox contained measures such as a temporary franc peg to the euro, Hildebrand opted for a policy that allowed the SNB to maintain its rate-setting independence. By imposing a ceiling against the euro, the central bank went a step further than last year, when policy makers intervened over 15 months without setting a target.

Israel to Hong Kong
Policy makers had been under increasing pressure to act after lawmakers, facing October general elections, joined executives in calling on the SNB to step up efforts to weaken the currency. All five ruling-coalition parties at a Bern meeting on Sept. 2 pledged their support to the central bank.

Elections mean that preventing a recession and job cuts in the short term have become more important than possible inflation threats down the road,” said Daniel Kalt, an economist at UBS AG in Zurich. “We’ll only see in two or three years whether it was the right decision.”

Other central banks have already seen surging prices in the wake of efforts to weaken their currencies. The Bank of Israel’s currency purchases have helped keep inflation above the government’s 1 percent to 3 percent range since January. In Hong Kong, the local dollar’s peg to the greenback has left the economy exposed to surging consumer-price growth.

While SNB policy makers opted to maintain their independence over tying the franc to the euro, Ulrich Kohli, the bank’s former chief economist, said it will be “very difficult” to withdraw liquidity.

“The SNB’s intervention policy has a range of consequences that should be taken seriously,” he said in a telephone interview. “The liquidity will remain in the system for a very long period of time.”

To contact the reporter on this story: Klaus Wille in Zurich at kwille@bloomberg.net

To contact the editor responsible for this story: Craig Stirling at cstirling1@bloomberg.net

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