The Swiss National Bank stunned financial markets on Tuesday by setting a ceiling for the Swiss franc against the euro in an attempt to prevent the strength of its currency from pushing its economy into recession. The central bank said it would set a minimum exchange rate of SFr1.20 against the euro.
Scott Sumner is happy, Matt Yglesias is happy, and I am not unhappy but I am nervous. Keep in mind the Swiss tried such pegs before, in 1973 and 1978, and neither lasted. At some point limiting the appreciation of the Swiss franc implied more domestic price inflation than they were willing to tolerate (seven percent, in one instance, twelve percent in another). You can argue about whether they should be, or should have been, nervous about seven percent price inflation but the point is that they were and indeed they might be again.
Fast forward to 2011. It’s the Swiss saying “we can create money more decisively and more quickly than the speculators can bet against us, and keep it up.” If the flight to safety continues, the Swiss can reap seigniorage by creating money but also there may be spillover into price inflation. You can fix a nominal exchange rate but the market sets the real exchange rate through price movements and so Swiss exports could end up growing more expensive anyway, through the price adjustment channel. If you’re holding and trading euros, and the Swiss central bank keeps churning francs into your hand at a good rate, at some point you will consider buying a chalet in Schwyz.
If the speculators sense less than a perfectly credible commitment from the central bank, they will continue to bet on franc appreciation. In other words, the Swiss are putting their central bank credibility on the line, at least in one direction. And even if they stay credible, they may not much lower their real exchange rate over a somewhat longer run, so why should they be fully committed to credibility?