Paul Krugman has a post discussing the recent Swiss move to sharply appreciate their currency, despite deflation in Switzerland. I agree with much of what he has to say, but not everything:
Two things to bear in mind. First, having in effect thrown away its credibility – in today’s world, the crucial credibility central banks need involves, not willingness to take away the punch bowl, but willingness to keep pushing liquor on an abstemious crowd – it’s hard to see how the SNB can get it back.
That’s not quite right. It’s very easy to see how they could get it back—simply re-peg the SF at 1.20/euro. The second peg would be much stronger than the first, because the markets would think the following:
“Wow, what a humiliating reversal from the SNB! The result of letting the SF float must truly have been catastrophic for them to do such an embarrassing about face after 3 days. Obviously they won’t ever make that mistake again. The new peg will be solid as a rock!”
It’s easy to see how they “can” get it back. Rather what Krugman should have said is “it’s hard to see them getting it back.” And he would have been right. I can’t imagine the SNB re-pegging at 1.2, and hence future SNB promises will be less likely to be believed. Ditto for promises from other central banks.
Update: Andy Harless beat me to it. And several commenters pointed out the SNB is already thinking about depreciating the SF. But you know they won’t go all the way back to 1.20, which means they’ll have to try much harder.
But the real problem is not lack of credibility; it is that central banks have the wrong target. If they would actually target inflation at 2%, or NGDP growth at 5%, the markets would believe them. Why wouldn’t they be believed? The markets aren’t stupid. Yes, they’ll get blind-sided occasionally as we all were by the Swiss, but (on average) markets will forecast central banks to do exactly what they will do. Do it and markets will believe.
Back to Krugman:
These days it’s fairly widely accepted that it’s very hard for central banks to get traction at the zero lower bound unless they can convince investors that there has been a regime change – that is, changing expectations about future policy is more important than what you do now. That’s what I was getting at way back in 1998, when I argued that the Bank of Japan needed to “credibly promise to be irresponsible,” something it has only managed recently.
Krugman thinks the problem is the zero bound, but that claim is simply no longer plausible. The Fed is itching to raise rates around mid-year, despite 10-year inflation forecasts that are far below 2%, and even worse the Fed is officially targeting PCE inflation, which run 0.3% to 0.4% below the CPI inflation embedded in TIPS spreads. There’s a reason markets don’t expect 2% inflation; the Fed is behaving as if it is targeting inflation at slightly below 2%. When we were at the zero bound you could have made a semi-plausible claim that it was all due to monetary policy impotence (even though that claim was false) but that view no longer has any plausibility in a world where the Fed is about to raise rates.
(In my monetary offset posts I used to get hammered by the argument, “but surely you agree the Fed would prefer inflation to be higher?” OK, where are you guys now that the Fed is about to raise rates?)
I wish I could recall the post I did around 2009 or 2010 where I said the validity of market monetarist arguments would be much more obvious when we finally exited from the zero bound. (I based that on the fact that the causes of the Great Depression became much easier to see during the long recovery period.)
The “promise to be irresponsible” argument is also false. Central banks need to promise to be responsible. They need to set a price or NGDP level target, and promise to do whatever it takes to hit that target. Krugman is wrong when he claims the BOJ has recently been irresponsible (meaning that it has generated high inflation.) It has not done so. Apart from the one-time boost from higher sales taxes, Japanese inflation has been running around 1%. That’s better than the deflation they used to suffer, but it falls short of their 2% target. Being irresponsible has nothing to do with it. BTW, the Swiss move makes me more inclined to believe the Japanese will quietly give up on their 2% inflation target.
In my comment sections I see continued confusion about central bank balance sheets. People seem to think that the Swiss needed to let their currency float to avoid a big balance sheet. Over at Econlog I explain why letting the currency float will lead to a bigger balance sheet than the previous peg (especially if you hold IOR constant—recall they could have lowered the IOR to negative 0.75% without breaking the exchange rate peg.)
Maybe the following analogy will help. Imagine a teenage girl that is depressed about her looks, and spends all day lying on the couch eating Ben and Jerry’s ice cream, and watching TV. She doesn’t want to change her behavior, but wants to look slim and pretty. What do you tell her?
Now imagine a central bank that wants to run a deflationary monetary policy, but insists it doesn’t want a big balance sheet. What do you tell it? The SNB reminds me of that teenage girl.
PS. Tyler Cowen has a good post on the ECB’s anticipated QE program. I am equally skeptical. It will probably help a little, but the good that will result is probably already priced into the euro/dollar exchange rate. That’s not nothing, but it’s far short of what’s needed in the eurozone.
PPS. Some commenters have criticized my support of fixed exchange rates. I oppose fixed exchange rates. It’s just that the Swiss 1.20 peg was less bad that what came before or after. There are degrees of badness.