You may recall that in September the Swiss National Bank (SNB) announced that it was going to intervene as necessary in the currency markets to ensure that the Swiss Franc (CHF) stayed above a minimum exchange rate with the euro of 1.20 CHF/EUR. How has that been working out for them?
It turns out that it has been working extremely well. Today the SNB released data on its balance sheet for the end of September. During the month of August the SNB had to spend almost CHF 100 billion to buy foreign currency assets to keep the exchange rate at a reasonable level. But in September -- most of which was after the announcement of the exchange rate minimum -- the SNB's foreign currency assets only grew by about CHF 25 billion. Furthermore, this increase in the CHF value of the SNB's foreign currency assets likely includes substantial capital gains that the SNB reaped on its euro portfolio (which was valued at about €130 bn at the end of September), as the CHF was almost 10% weaker against the euro in September than in August. Given that, it seems likely that the SNB's purchases of new euro assets in September after the announcement of the exchange rate floor almost completely stopped.
But why would the SNB's promise of unlimited intervention in currency markets have led to a near total cessation of those interventions? Didn't they say they would intervene more, not less?
This is a beautiful demonstration of the almost magical power that central banks can sometimes have when they target prices instead of specifying a certain quantity of intervention. Market participants correctly believed that the SNB's promise to keep the CHF/EUR rate above 1.20 was perfectly credible. As such, no one was willing to try to accumulate CHF at a price inconsistent with that floor. In fact, there has been some sense in the market that this 1.20 rate was going to be increased, which would guarantee losses for anyone holding CHF assets. As a result, market demand for CHF has fallen dramatically and the exchange rate has drifted up above the 1.20 floor set by the SNB -- all with little or no actual intervention required by the central bank.
This should be a reminder to other central banks that when they target prices by promising unlimited intervention, the market will often do most of the work for them and respect that price target out of its own self-interest.
So let's apply this lesson to another situation: the doom loop that the market for Italian debt seems to have entered. Imagine that the ECB declared an interest rate ceiling and stated that it would not allow the rate on Italian bonds rise above some clearly specified spread over German interest rates. (Obviously this should be at an interest rate consistent with long-run Italian solvency.) And imagine that the ECB backed up that interest rate ceiling by promising unlimited intervention to support it. Since the ECB can make good on that promise by simply creating more euro -- which it can do in unlimited quantities -- market participants would understand that there is no way they could break the interest rate ceiling set by the ECB. And as a result, it is entirely possible that the ECB could achieve its price target on Italian debt with minimal intervention, just as the SNB achieved with its exchange rate floor.
What's preventing the ECB from doing that? Caution, conservatism, and politics, of course. But the Swiss Franc experience reminds us that, from an economic perspective, price targeting by a central bank can sometimes make very good sense.