The SNB’s decision and power of expectations in monetary policy

After the Great Recession hits, it’s becoming increasingly popular that central banks employ “expectations” as a part of their monetary policy. The Federal Reserve has been actively using communication policies (the most famous one is called “forward guidance”), which essentially means the Fed makes some promises regarding its future policy path to make the policy more effective. The Federal Reserve explains how this kind of policy works as follows:

By providing information about how long the Committee expects to keep the target for the federal funds rate exceptionally low, the forward guidance language can put downward pressure on longer-term interest rates and thereby lower the cost of credit for households and businesses, and also help improve broader financial conditions.

This is a very clever idea as it sounds, since central banks could strengthen their policy without using “official” policy variable in their toolkit. Only they have to do is to put “language” into their communication with general public (such as monetary policy statement and press conference). And this is the part of reasons why many central banks employ the similar strategy. For example, in the middle of the euro crisis in 2012, the ECB president Mario Draghi said that “the ECB is ready to do whatever it takes to preserve the euro”, which became very popular phrase both among policymakers and financial markets. In response to this statement made in the press conference, yields on sovereign debts in troubled countries immediately went down. Yes, the policy (just one sentence!) to control “expectations” worked perfectly.

Then here comes the SNB. In the most recent policy meeting, the Swiss National Bank decided to give up its cap on the Swiss franc exchange rate. In other words, the SNB suddenly “broke a promise” that it does “whatever it takes” to stabilize its currency. The price of betraying expectations seems very high, since the Swiss franc exchange rate surged and Swiss stock market tumbled right after the decision. Although the SNB also decided to lower its policy interest rate further into deeper negative territory, it did little to offset the shock in financial markets.

Here is a lesson that other central banks have to learn: policymakers should be very careful when they incorporate expectations into part of their policy, and abandoning this kind of policy could result in huge turmoil in financial markets. And since different policy settings have different policy implications, central bankers have to be sure that how they keep consistency among the policy to control expectations and other economic policies.

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