1. 1 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Rules in the Conduct of Swiss Monetary Policy Norges Bank Workshop May 5 and 6, 2003 Thomas J. Jordan Head of Research Swiss National Bank

2. 2 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Contents u Part IElements of the SNB's monetary policy framework u Part IIThe decision-making process u Part IIIThe SNB framework and policy rules

3. 3 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Part I: Elements of the SNB’s monetary policy framework

4. 4 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 The SNB framework: overview After 25 years of monetary targeting, the SNB adopted a new monetary policy framework at the end of 1999. Although the ultimate goal of maintaining price stability has remained unchanged, it was the most important adaptation of the SNB’s strategy since the transition to flexible exchange rates in 1973. The framework consists of three elements: u An explicit definition of price stability u An inflation forecast as the main indicator for policy decisions u A target range for the 3M-Libor (London Interbank Offered Rate) as an operational target

5. 5 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Element I: An explicit definition of price stability u Price stability is defined as an annual CPI inflation of less than 2%. (same definition as the ECB). The definition of price stability takes into account the measurement bias in the CPI of approximately 1.0% and an uncertainty range of ± 1%. u The definition of price stability delivers the nominal anchor for the medium- term orientation of monetary policy and is the benchmark for the accountability of the SNB.

6. 6 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Element II: Inflation forecast as the main indicator u Monetary policy decisions are based on a consensus inflation forecast extracted from the information from different models and indicators. u There is no mechanical reaction to the forecast; the forecast is rather used as the main indicator. u The inflation forecast serves as an important means of communication for explaining the policy decisions and the current stance of monetary policy to the public. u The forecast is published quarterly as a point forecast under the assumption of an unchanged 3M-Libor. The forecast horizon is 3 years due to long lags in the monetary transmission mechanism.

7. 7 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Element III: A target range for the 3M-Libor u The SNB specifies its monetary policy decisions by setting an operational target range for the 3M-Libor with a width of normally 100 basis points. u The SNB usually announces the position where it wants to have the 3M-Libor within the target range (middle, upper, or lower part). u A longer-term interest rate (i.e., 3M instead of overnight) and a large width for the target range allow for some flexibility in the very short run to react to market and exchange rate disturbances without having to change the stance of monetary policy.

8. 8 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 SNB framework differs from typical inflation targeting u The concept knows no inflation target but rather a definition of price stability: –It should be valid for an extended period of time. –It should only be changed for economic and not for political reasons. u The SNB does not only have instrument independence but also substantial goal independence (within the limits of its mandate): The SNB determines the exact definition of price stability. u The inflation forecast is not used as an intermediate target but rather as the main indicator. u The time horizon after an inflationary shock to return to the range of price stability is not determined in advance. u There is no attempt to fine-tune the inflation rate but rather to follow a medium-term stabilization. There is no obligation to keep inflation under all circumstances in the range of price stability.

9. 9 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Part II: The decision-making process

10. 10 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Timing of forecasting and the policy decision at the SNB: regular quarterly basis Defining scenarios for the international business cycle: Base scenario and risk scenarios (board approval ) Report and policy suggestion to board Meeting of board with policy decision Computing consensus inflation- forecast from model forecasts and indicator information T-6 weeks to T-5 weeks T-4 weeks T-3 weeks to T-1 week T

11. 11 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Internal analysis u Forecasts and simulations with several models (traditional macro models, structural VAR models) for base and alternative scenarios u Model simulations with different policy rules: –Unchanged 3M-Libor –Taylor-type rules –Forward-looking rules u Analysis of important indicators (money and credit aggregates, equilibrium exchange rates, term structure of interest rates, output gap etc.) u Synthesis of information from models and indicators to a consensus forecast (no fixed weighting) u Computing consensus forecast for different levels of unchanged 3M-Libor (usually for current level of 3M Libor and ± 50 or + 50/+100, -50/-100 pb)

12. 12 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 The inflation forecast and the policy decisions u The board considers the inflation forecasts for the different levels of interest rates and the different risks scenarios. u In general the board chooses a 3M-Libor which avoids a persistent departure of the inflation rate from the range of price stability. A temporary departure from the range of price stability does not automatically signal a need to change monetary policy. Due to the lags, monetary policy may not be able to control inflation in the short run. u However: There is never a mechanical reaction to the inflation forecast. The inflation forecast serves only as a main indicator. u Other aspects may be important for interest rate decision: Exceptional circumstances, timing, experience and judgment of central bankers in specific situations, etc. u Monetary policy can even be changed without explicit computing of a new inflation forecast.

13. 13 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 03 Feb preannounced date 20 Jan non-preannounced date 23 Mar preannounced date 15 Jun preannounced date 22 Mar preannounced date 17 Sep preannounced date 24 Sep non-preannounced date 07 Dec preannounced date 02 May non-preannounced date 26 Jul non-preannounced date 06 Mar non-preannounced date

14. 14 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Example: The inflation forecast published in December 2001

15. 15 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Interpretation of the published forecast u Although the forecast horizon extends over the subsequent three years, the individual forecast itself is valid for three months at most. u Although the forecast assumes an unchanged 3M-Libor, it is highly unlikely that the 3M-Libor remains unchanged over the subsequent three years due to the reaction to new shocks and information. u If inflation at the end of the forecast horizon is neither close to 2 or 0 percent nor displays any type of sustained trend, the published forecast offers no hint of potential changes in the 3M-Libor over the following three months. u However, a published forecast with an upward inflation trend or even a rate above 2% at the end of the forecast horizon indicates that an increase in interest rate is more likely than a decrease in the future.

16. 16 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Part III: The SNB framework and policy rules

17. 17 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 The significance of rules for the SNB’s monetary policy u The SNB has never mechanically applied an instrument rule for its policy decision. In the individual decision, the SNB acts discretionary. u However, the SNB has always tried to systematically use data and information from indicators and models in order to achieve its ultimate goal of price stability in a consistent manner over time. u The goal of maintaining price stability limits the degree of discretion. This "constraint discretion" is the kind of rule consistently applied through various concepts for over 25 years.

18. 18 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Taylor Rates and 3M-Libor in Switzerland

19. 19 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 The SNB framework as a targeting rule framework The current SNB framework can be largely interpreted as a general targeting rule framework; however, the general targeting rule is applied in a very flexible and broad way: –No explicit loss function –Medium term orientation (no inflation target, but definition of price stability, no explicit targeting horizon) –Multi-model approach (high model uncertainty; single indicators, judgment very important;) –Broad view and flexibility in certain circumstances for possible other aspects as e.g. financial imbalances, exchange rate –Timing, tactics, signaling important

20. 20 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Medium-term orientation of monetary policy u The SNB does not endeavor a fine-tuning of inflation and the output gap. u There is a limited power of monetary policy in steering the economy. u The available knowledge of the transmission mechanism is not perfect. u Excessive exchange rate movements may lead to policy adjustments.  More modest objective of keeping inflation at a medium-term horizon within the rage of price stability by taking the business cycle situation into account.

21. 21 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Flexible reaction and tactics u There is no fixed reaction to deviation of forecast from the definition of price stability. Even an interest rate cut is possible although the forecast is on an upward trend (Example March 2003). u Often tactics (size of interest rate change; timing) is important in order to give strong signals to the market (Example March 2000: Increase of 75 basispoints: more and earlier than the ECB).

22. 22 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Example: The inflation forecast published in March 2003

23. 23 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Importance of performance u Reputation and credibility are crucial for being able to pursue a flexible medium-term oriented monetary policy. u Past performance builds up reputation and credibility. u Central bank independence must also be warranted through past performance.

24. 24 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Inflation performance of SNB new concept

25. 25 Rules in the Conduct of Swiss Monetary Policy May 5 and 6, 2003 Concluding remarks: Are specific targeting rules necessary? u The idea of a very general targeting rule describes quite well the actual policy process of the SNB. u However, it is doubtful whether an attempt to introduce a specific targeting rule would improve policy making: –Loss functions differ between policy makers and may not be constant over time and policy makers do not usually think in terms of an explicit loss function. –Using specific targeting rules may easily lead to an overestimation of the possibilities of monetary policy given the high uncertainty about transmission mechanism, output gap, and natural real interest rate. –Multi-model approach/indicator becomes difficult to apply with specific targeting rules. –Policy makers may have a broader view: e.g. financial imbalances, exceptional circumstances etc. which cannot be captured by specific targeting rules.