Those Who Don’t Like QE Should Root for A Higher Inflation Target

By Jan 10, 2013, 12:31 PM Author's Blog  

The Wall Street Journal has a good article on the dilemma facing the Swiss National Bank:

Nearly every major central bank is buying nontraditional assets to resurrect domestic economies in the wake of the worst global recession in 75 years. The U.S. Federal Reserve is buying mortgages; the European Central Bank is making unusually long loans to banks; and the Bank of Japan is buying real-estate investment funds.

All risk losing money, but Switzerland’s exposure stands out in character and scale: Its central bank is buying assets from other countries and its holdings of currencies, bonds, stocks and gold—nearly 500 billion Swiss francs, about $541 billion—are nearly the size of the nation’s gross domestic product. In contrast, the Fed’s buying of bonds and mortgages amounts to about 20% of U.S. national output, and the European Central Bank’s holdings stand at 30% of total GDP.

In September 2011, the SNB set a goal of keeping its currency from rising beyond 1.20 francs to the euro, a threshold that SNB Chairman Thomas Jordan has said the bank would fight to maintain “with the utmost determination.”

The strategy, so far, is working. The franc hasn’t crossed the 1.20 threshold in 16 months. The Swiss economy is growing, albeit slowly, while the euro-zone economy is contracting. Inflation is nonexistent, though rising real-estate prices are prompting worry. Exports are up despite the euro-zone recession.

.  .  .

“The SNB is acting very much like a leveraged hedge fund,” Bruce Krasting, a former currency trader, wrote on his blog. “It’s making currency ‘bets’ with the people’s money. It’s taking some very big risks.”

Switzerland’s central banker acknowledged the risks but said there was no alternative. “It’s not excluded that we could suffer a loss, but the risk of doing nothing was greater,” Mr. Jordan, the Swiss central banker, said in an interview. “The franc was so strong that we could have fallen into a deflationary spiral.”

At the zero lower bound central banks face three choices:

1.  Become passive, and fall into a deflationary spiral.

2.  Maintain the inflation target, and buy as much as it takes to insure the target is hit.

3.  Raise the inflation target, allowing the central bank to dramatically shrink its balance sheet (as a share of GDP.)

Most people don’t understand this, they believe moving from step two to step three would require a larger balance sheet.  Australia maintains a slightly higher inflation target than the Fed, ECB, or SNB, has positive interest rates, and has a monetary base of only 4% of GDP.

And deflation really isn’t much of an option.  Eventually politics will force the central bank to act:

The Swiss feared entire swaths of industry would disappear forever. “There is no way within one or two years to recover such an enormous amount of price competitiveness,” said Hans Hess, president of Swissmem, which represents around 1,000 mechanical and engineering companies. “There was a risk that a significant number of Swiss export companies would either have been wiped out or have had to leave Switzerland.”

So it’s print money now or print money later.  If you really, really don’t want to see a lot of money printing, negative IOR might help, but higher trend inflation is the only real alternative.

I’m not sure what the SNB should do.  The same article suggests they are dabbling in securities:

Unlike big private investors, the SNB can’t hedge its foreign-exchange risk. To limit its euro exposure, the SNB has moved to diversify and now holds 12% of its reserve in foreign equities, unusual for a central bank. It has traded euros for U.S. dollars, British pounds, Australian dollars and others.

Last year, it began buying South Korean won and recently said it would station seven people in Singapore to facilitate “round-the-clock operations” in foreign-exchange markets.

As of the end of September, the latest data available, 48% of its holdings were in euros—down from 60% at midyear—28% in U.S. dollars and 24% in other currencies.

“I never thought I would ever see such an anti-inflationary conservative institution as [the SNB] hold our currency as part of their reserves,” said Australian central banker Glenn Stevens. “It’s a remarkable thing.”

Notice how my favorite economies all end up with governments owning lots of foreign equities?  It goes against Switzerland’s conservative ideology.  But as I’ve argued many times, a bit of socialism might be the price you pay for a conservative monetary policy.  The lower the inflation target, the greater the quantity of assets that must be purchased by the central bank (as a share of GDP.)

Even though I am a libertarian, I’d be hard pressed to predict disaster for Switzerland.  Obviously this particular gamble might fail, but in the long run a strategy of borrowing money from Europeans at zero interest rates and investing in Asian equity markets would be expected to yield a positive rate of return, if only due to the Balassa-Samuelson effect.  Countries like Switzerland and Singapore get rewarded for their virtue.   They borrow at low rates and run massive current account surpluses.  Their thrift allows them to keep tax rate slower than their neighbors.  And their relatively low tax rates keep their economies richer than their neighbors.  These two countries have the highest share of millionaires in the world. Singapore decided to create a sovereign wealth fund many years ago. And now the logic of its position is pushing the Swiss in the same direction.

This example also highlights the real issue created by the zero lower bound.  The question is not; “will QE work or not?” There is always some level of QE that will work. The real question is whether central banks prefer a lower inflation target with a large balance sheet, or a modestly higher inflation target with a smaller balance sheet.

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