I have written a couple of comments on other blogs about the Swiss National Bank's decision to let the Swiss Franc float, and the resulting 20 percent appreciation against the Euro. The SNB held a substantial amount of Euro denominated assets, and so the result was heavy financial losses. The rise in the value of the Swiss Franc will result in cheaper imports from the Euro-zone, and so exacerbate consumer price deflation in Switzerland. That is inconsistent with the Swiss National Bank's inflation target.
Robert Murphy reproduced a graph that showed a large increase in the Swiss monetary base. It was approximately equal to Swiss GDP. I wrote a comment pointing out that creating base money is easy. What is the problem?
Of course, I do realize the problem is possible losses on the assets that the Swiss National Bank is purchasing. I discussed that in a comment on a post on Sumner's Money Illusion blog. He reproduced it in a later post on Econlog. If the demand for Swiss base money increases temporarily, then the proper response is for the SNB to expand the quantity temporarily. However, if it finds itself purchasing risky assets to match the added liabilities, then it should lower the interest rate it pays on reserve balances, perhaps below zero. As Koning pointed out in a post on his blog, if the interest rate on SNB reserve balances falls below zero, then this will create an incentive to hold currency. This would be an incentive by banks (especially Swiss ones) to hold vault cash and for people to keep currency in safe deposit boxes. I endorsed Koning's point that if the SNB is charging for reserve balances, then it needs to stop issuing large denomination banknotes convenient for hoarding. I argued that it should limit its issue of currency to denominations appropriate for retail trade in Switzerland.
Now, I don't believe that the SNB should be targeting the Euro or consumer price inflation. The SNB should not worry about deflation of import prices, but only the impact on the demand for Swiss exports and the secondary effect of import deflation on the demand for Swiss import competing products. Well, more exactly, it should be targeting Swiss nominal GDP which includes exports and import-competing (and other) Swiss goods and services.
Given its close trading ties to the Euro-zone, keeping nominal GDP growing on a stable growth path (say 3 percent) would likely result in depreciation of the Swiss franc relative to the Euro as long as the ECB continues with a deflationary policy. A commitment to allowing the Swiss franc to depreciate in that way would tend to reduce the demand for Swiss francs. Or at least, it will tend to reduce the demand for currency issued by the SNB and by refraining from raising the interest rate paid on reserve balances, the SNB could reduces the demand for reserve balances. Swiss banks, similarly could limit the increase in deposit interest rates to limit growth in their deposits.
Murphy's response to my brief comment on his blog was to describe a scenario where the huge increase in the quantity of Swiss francs starts to cause inflation. The SNB needs to reduce the quantity of base money to prevent the inflation. But at that same time, the Swiss franc rises relative to the Euro and so the SNB takes large losses on Euro-denominated assets. More importantly, sales of these lower valued Euro-denominated assets will cause a smaller reduction in the the quantity Swiss base money. In the extreme, the SNB may not be able to reduce its issue of base money enough to prevent inflation because it lacks sufficient assets to sell.
The first problem with the argument is the presumption that any increase in the quantity of money is inflationary. While this is true if we start in equilibrium and the demand for money is held constant, it is false if the quantity of money only rises to match an increase in the demand to hold money. It is supply and demand, not just supply.
So, the worry isn't some kind of inevitable inflationary impact of an increase in the quantity of Swiss francs, but rather the possibility that the demand to hold Swiss francs might fall. The SNB must be in a position to sell off assets and reduce the quantity of Swiss francs to match possible reductions in the demand to hold them.
Now, how exactly is it that the Swiss franc is going to appreciate against the Euro in this scenario? If anything, the reduction in the demand to hold the Swiss franc would cause it to depreciate. This would increase the value of Euro-denominated assets and make them more able to absorb Swiss francs when sold.
Suppose that the Euro-zones deflationary problem shifts to inflation. This could cause the Euro to depreciate. And so now, the SNB has Euro-denominated assets that have lost value. But is this realistically a situation where the demand for Swiss francs would fall? Wouldn't inflation in the Euro-zone instead result in a higher demand for Swiss francs?
And finally, as Sumner has pointed out, maybe the SNB should diversify its asset portfolio--don't just purchase Euro-denominated assets, purchase dollar (and yen) assets too. Remember, the problem isn't that the increase in the quantity of base money is inherently inflationary. It is to avoid net losses on the SNB's asset portfolio.
Consider a scenario that has been common in history, but far removed from the current situation:
Suppose the SNB was propping up the Euro by purchasing Euro-denominated assets. The problem is that the Euro zone is suffering from inflation and the SNB is responding to concerns by Swiss exporters. A higher Swiss franc will hurt their sales and profits. The SNB is purchasing Euros with newly-created Swiss francs, causing an excess supply of Swiss francs. Eventually (after the long and variable lags,) this excess supply of Swiss francs will lead to inflation in Switzerland. It would be a classic case of imported inflation. If and when the SNB gives up on the policy and no longer supports the Euro, the Euro will fall. Just when Switzerland needs to reduce the quantity of Swiss francs, its Euro-assets will have fallen in value.
Well, that would be a bad policy. But that is not what is happening. The demand for Swiss francs has risen. And the SNB needs to accommodate the higher demand to hold its liabilities by issuing more or else come up with a way to dampen the increase in demand by lowering the interest rate paid (or raise the amount charged) for deposit balances. As for hand-to-hand currency, it can quit issuing denominations convenient for large scale hoarding. I believe that the SNB, like other central banks, should get out of the hand-to-hand currency business, so that this would not be a policy matter, but rather a decision by private banks to limit their issue of hand-to-hand currency when they find it profitable to do so.