Tactics and strategy in monetary policy: “Benjamin Friedman's thinking and Switzerland National Bank” by Stefan Geriach and Thomas Jordan April 2011 Ahmad Bash 1

40 years ago, Ben Friedman first article appeared with title “tactics and strategy in monetary policy”(Friedman, 1971) for staff group of the FOMC lead to widely cited 1975 paper with title “Targets, instruments and indicators of monetary policy”(Friedman, 1975) Ben has become one of the most distinguished scholars of monetary policy after his writings about Monetary Policy. His writings and thinking has been highly influential on central banks beyond the USA such as the SNB SNB operates with floating exchange rate regime after the breakdown of the Bretton wood system SNB has faced very same issues that have occupied such as prominent part of Ben’s professional life 2

Ben’s work since 1971 and monetary policy in Switzerland have some similarities in many cases and some divergence in some issues We will review the tactics and strategy of monetary policy in Switzerland by focusing on three episodes Section 1: we review Ben’s views about monetary targeting before looking at the SNB’s experience with targets in Section 2: we turn to the policy strategy adopted by the SNB in 2000 in which inflation forecast plays a crucial role Section 3: we review the SNB’s experience during the financial crisis that started in august

Ben on monetary targeting Ben was never been a proponent of monetary targeting to achieve monetary targets since he felt it disregards useful information He writes that “central bank should look at everything in a particular way which yields the maximum useful information and should avoid relying on a particular intermediate target variable” (Friedman,1975) He notes that “FOMC should not seek to control the money stock as an intermediate target of monetary policy” (Friedman,1977) Ben makes a point that the theory and practice of monetary targeting might differ considerably In practice, central banks may use more indicators than simply the targeted aggregate and by doing so, they may have avoided some of the difficulties resulting from controlling the money stock tightly In regards to controllability of the aggregates, Ben argued that tight, short- run control was neither possible, desirable nor necessary. Therefore, Ben felt that even if it might be possible to control money aggregates sufficiently well to practice monetary targeting, such a policy would be undesirable unless the central bank also used the information from other variables 4

The SNB and monetary targeting After adopting floating exchange rate in 1973, the SNB conducted policy without a nominal anchor However, SNB believed that a clear nominal anchor was necessary to enhance transparency and accountability. At the end of 1974, it announced an intermediate monetary target which was motivated by the SNB desire to support its anti- inflationary policy During the course of the decade, SNB has expended a great deal of effort in convincing the public that “price stability” should serve as the main objective of monetary policy After gaining experience with monetary targeting, SNB realized that many of the arguments raised by Ben were justified. Its monetary targeting strategy evolved accordingly over time, but maintaining price stability in the medium term should be the main objective remained unchanged even after the period of monetary targeting 5

Period 1:M1 as the target and the monetary base as the instrument The SNB 1 st monetary targeting strategy followed 2 stage approach analyzed by Friedman 1975: 1)announced intermediate target: annual M1 growth for the next year. 2) controlled M1 by way of monetary base. Finally an operational target for bank reserves was established Neither the objective for the monetary base nor the target for bank reserves was announced. The reason behind using MB instead of interest rate is that Switzerland lacked a well developed money market. In addition, the SNB had concluded that price stability could not be maintained unless the balance of payments surpluses and the resulting expansion in the monetary base were reduced Therefore, trend growth in the monetary base had come to be seen as the best indicator of monetary conditions Given the limited availability of data and limited ability to forecast at that time, money was seen as the most important information variable. However, SNB was pragmatic and also considered other information variables. The SNB was ready to deviate from the monetary target if a conflict arose between this target and the maintenance of price stability. 6

Following the adoption of monetary targeting, inflation fell quickly and reached 1% in The sharp appreciation of the exchange rate in helped reduce inflation. However, SNB became concerned about the consequences of economic activity and the risk of deflation. The Swiss authorities tightened various restrictions on capital inflows but these measures had little effect on the exchange rate. In 1978, SNB announced a temporary exchange rate target by setting a floor under SF/DM and elected not to adopt a monetary target for To defend the objective: The SNB increased M0 and M1. Short-term interbank rates fell to zero early in 1979 While exchange rate depreciated, the rise in inflation in the early 1980s was due to sharp rise in money growth during exchange rate objective period (halting appreciation lead to inflation) 7

Period2: Targeting the monetary base After exchange rate have calmed down, SNB announced new monetary target (monetary base M0 rather than M1) for Thus MB is not only an intermediate, but also operational target! 8 M0 (reduce the growth to 2% gradually) M1 - Closely related to the SNB’s ultimate target of price stability - More stable and less sensitive to interest rate - Difficulty in forecasting the multiplier when there is sharp exchange rate fluctuations

In , SNB did not reach the target because of the need to tighten monetary policy to prevent inflation From , the SNB largely achieved its targets. In 1987, it overshot the target on purpose, in response to an appreciation in SF as well as the stock market crash. In 1988, bank demand for base money fell more sharply than the SNB had anticipated because of the introduction of new electronic interbank payment system and a revised reserve framework These shocks rendered M0 temporarily of little value and SNB relied on interest rates to asses monetary conditions In , the SNB again decided that money growth had to be reduced below target because of a decline in money demand and a need for tighter policy As Ben would have proposed, the SNB considered range of factors such as exchange rate, stock prices, financial innovations in conducting monetary policy In 1990, the SNB could not prevent inflation from increasing above 6%. It could have achieved better performance if it had paid greater attention to credit growth and broader monetary aggregates 9

Period3:Medium-term targets for M0 from 1990 to the mid 1990s In 1990, the SNB shifted to medium-term target to allow to react flexibly to temporary shocks without forgoing the monetary anchor The target was described over 5 years period and indicated by movement in M0 that was judged to be consistent with price stability and potential real growth of 2% per annum. However, while base growth was seen as informative for inflation in the medium run, it was not seen as a good predictor of short term movements in inflation. Instead, SNB would look at other indicators and when necessary let money growth deviate from the target Financial innovations in 1980 has altered the composition of the monetary base and weakened the SNB’s control over the monetary base (it now took few months for an easing in Monetary Policy to affect the MB) 10

Because of this lag, base money provided little information about the current stance of policy. Instead the SNB relied on short-term interest rate to asses monetary conditions. In 1997, the SNB forced to choose new target variable M3 which became reliable indicator for inflation in the longer run as M0 became unstable. In 1999, the SNB decided against doing so and instead abandoned monetary targeting Advanced in computer technology, data quality and quantity and improvements in the knowledge of the monetary transmission process facilitated the strategy change at that time 11

How near was the SNB’s monetarist pragmatism to Ben’s thinking? As suggested by ben’s work, the SNB allowed money growth to deviate from target when disturbances occurred. To illustrate this, regression for annual data for Y= money growth (target) X1: CPI inflation X2: change in real exchange rate The results show that SNB allowed money growth to vary relative to target in response to economic development Policy conducted during the monetary targeting period was compatible with Ben’s recommendations The intermediate monetary targets appear to have been mainly used as a communication tool to convey to the public the SNB’s commitment to price stability, rather than as end in themselves Under monetary targeting, the SNB achieved lower inflation than all other central banks. Thus, although the framework came to an end in the 2 nd half of 1990s, it laid the ground for the high credibility and reputation of the SNB 12

The SNB’s current framework In 1999, SNB announced monetary policy framework which has some features of inflation targeting (but which the SNB does not consider to be inflation targeting) To Ben, the Fed should focus on how best to conduct monetary policy without relying on formal money targets. That was what the SNB did when it recognized its policy framework When announcing the new framework, the SNB referred it as modified strategy for monetary policy and It is based on 3 elements: 13

The elements of the strategy 1.Explicit definition of price stability: increase in the CPI by less than 2% (main objective) 2.Broad based inflation forecast spanning 3 years: based on appropriate number of models and serves as the main policy indicator 3.Target range for 3 months Libor which is steered by 1 week repo transaction: it indicates the SNB’s short- term intentions in the money market * Target range rather than a point target allows the SNB to respond flexibly to money market and exchange rate shocks 14

Comparison with inflation targeting The SNB’s framework is sometimes seen as an example of inflation targeting that is implemented by other central banks Features of inflation targeting policy: 1.Clear price stability mandate with numerical inflation target announced to the public 2.Key role for an inflation forecast as an intermediate target 3.The announcement of a clear horizon for achieving the inflation target 4.Concern about the stability of the real economy 5.High level of transparency and accountability * SNB’s framework shares some important elements with inflation targeting. For example, price stability is the main policy objective 15

Despite these similarities, SNB does not characterize its strategy as inflation targeting because: 1.SNB defines price stability instead of setting a target for inflation 2.Its definition of price stability does not involve a floor such as point target 1%. Instead, SNB equates any positive rate of inflation below 2% with price stability 3.SNB will accept temporary deviations from the price stability zone if necessary (interest rate will not automatically be adjusted if the inflation deviates from price stability range because aiming to restore price stability too rapidly will harm the real economy) 16

What might Ben think? In a number of recent papers, Ben has been critical of inflation targeting strategies, and much of this criticism would appear to apply also to the SNB’s framework Ben argues that there is little, if any, empirical evidence that inflation targeting improves macroeconomic performance. More importantly, he argues that inflation targeting fails (Friedman, 2004) Despite major shocks, inflation and output were have been more stable under the current framework than before 17

Monetary policy and the crisis Asmaa Al Ajmi 18