The first interest rate decision that the Board of Directors of the Swiss National Bank made in many years without Thomas Jordan is an extraordinary one. It shows that the new SNB leadership wants to vigorously combat a slide towards deflation.
The National Bank Board of Directors, in its new composition, explains its assessment of the monetary policy situation to the media in Bern.
Denis Balibouse / REUTERS
Will it be 0.25 or 0.5 percentage points with which the Swiss National Bank (SNB) wants to counteract the fall in inflation? That was the question that worried all market participants and observers before the last quarterly interest rate decision by the Swiss National Bank (SNB) in 2024.
Now, on Thursday morning, the newly constituted Board of Directors, led by Martin Schlegel, announced its vote to reduce the SNB’s key interest rate by 0.5 percentage points to just 0.5 percent. It is primarily signaling that it recognizes a clear need for action and, similar to rapidly rising inflation, now wants to weaken the franc and vigorously stimulate the economy with a sharp interest rate hike.
In addition, the National Bank is still willing to intervene in the foreign exchange market if necessary, as it writes in its press release. This means it can further weaken the franc to a certain extent and thus limit the extent of imported inflation. However, it hardly made use of it in the first half of the year (more recent data is not yet available) and its latest step also gives priority to the interest rate instrument.
Surprised by sharply falling inflation
Inflation in Switzerland was 0.7 percent in November compared to the same month last year and was therefore still well within the SNB’s target range of 0 to 2 percent. However, prices had fallen by 0.1 percent compared to October. The decline was mainly due to lower energy costs and lower import prices due to the exchange rate effect.
But the SNB economists have been surprised by the extent of the price decline every time since the second quarter of 2023 and have had to revise their inflation forecast downwards. This now seems to have prompted them to send a strong signal.
For the current year, the SNB now expects inflation of 1.1 percent at the key interest rate of 0.5 percent, for the coming year it expects 0.3 percent and for 2026 0.8 percent.
The fact that an interest rate cut was imminent was to be expected and had already been tentatively announced by the SNB in the autumn. The reason for a rather cautious 0.25 percentage points was that there was no exceptional urgency either in terms of inflation or the economic situation, and that the National Bank had in the past lowered its key interest rate in quarter percentage point increments.
Before the decision, those expansionary-oriented financial market observers who considered it urgent to prevent inflation in Switzerland from sinking into negative territory with a strong stimulus and who believed that this was the expectation of medium-term inflation had voted for 0.5 percentage points at the top and are most likely to be able to prevent a renewed resort to negative interest rates. The new SNB Board of Directors has now adopted this view.
Will the signal have the intended effect?
For the next few quarters, the SNB expects global inflation pressure to ease and the global economy to grow somewhat faster, although it notes that this scenario is subject to significant risks. Increasing or easing geopolitical tensions and policy changes following the change of power in the US could materially change the outlook. In its base scenario, the SNB now expects slightly weaker growth of 1.0 to 1.5 percent for Switzerland in 2025.
The significantly reduced key interest rate will likely reduce the costs of mortgages, reduce existing rents somewhat and drive house prices up again. In its assessment of the situation, the SNB maintains that the mortgage and real estate markets remain vulnerable.
The SNB’s task is to ensure price stability while taking the economy into account. Changes in the exchange rate have the fastest impact on inflation. If the franc strengthens, imports become cheaper; if it loses value, it increases inflation (and the value of the foreign exchange reserves held by the SNB). Interest rate cuts that increase the interest rate differential with other countries make the franc less attractive and tend to weaken it. This is likely to be the initial intention of the significant reduction in key interest rates by 0.5 percentage points.
However, the decision is particularly remarkable given that the interest rate difference between the franc and the euro has widened significantly with the surge in inflation. Even before the interest rate cut, the yield difference on German and Swiss government bonds with a two-year term was significantly larger than the current inflation difference.
Although the franc has strengthened slightly relative to the euro in nominal terms this year, its real value has remained remarkably stable for a dozen years. Seen this way, it cannot be described as significantly overrated.
The SNB leadership’s second motive for the sharp interest rate cut is economic in nature. Interest rate cuts make investments cheaper and give a boost to assets such as real estate, the book values of bonds and, in principle, stocks. Market participants should feel more purchasing power and stimulate the economy with investments and additional consumption. The resulting increase in demand is expected to increase inflationary pressure and reduce unemployment.
However, the economic mechanism takes time and it is unclear how quickly and sustainably it will work. In addition, the Swiss economy is still in fairly good shape. For the next few quarters, the SNB expects global inflation pressure to ease and the global economy to grow somewhat faster, although it notes that this scenario is subject to significant risks. Increasing or easing geopolitical tensions and policy changes following the change of power in the USA can materially change the outlook. In its base scenario, the SNB now expects growth of between 1.0 and 1.5 percent for Switzerland in 2025.
Prevention of deflation and negative interest rates
The larger than usual step by the SNB signals either a serious fear of deflation, i.e. that price developments could become negative over a longer period of time, or the will to keep inflation and thus inflation expectations no longer in the lower half of the target range or close to it to tolerate from zero. In theory, the changed expectations should also increase the probability that the SNB will not have to resort to negative interest rates again.
But concern and uncertainty also increase reluctance to buy and invest. In times of negative interest rates, the propensity to save increased to some extent and did not decrease. There are also valid arguments that real economic growth cannot be influenced by monetary policy in the long term and that too much stimulus only leads to more inflation.
In its first decision in its new composition, the new leadership of the SNB proved to be a monetary policy “dove” and wasted considerable amounts of money. We can only hope that this achieves its goal and doesn’t just fizzle out.
More to come.
