Thursday, May 31, 2012

The Danger of Promises

Promises are powerful, so don't make a promise you can't keep

Evan Soltas had an interesting post on the power of promises in the context of currency bands and monetary policy, but we should also remember that banks shouldn't try to make promises they can't keep. We all should be very worried when we see graphs that show sudden decreases in volatility, as Evan shows in his post. Whenever policymakers suppress volatility, we need to wonder where those pressures have gone, and why they have disappeared. More often then not, manufactured stability leads to calm periods punctuated by sudden change; they become Type 2 extremistan regimes, as pictured below:

So why did the currency peg work? The peg only makes sense in the context of Scott Sumner's argument that the currency peg is a form of monetary policy commitment. The undervalued currency increases aggregate demand, thereby filling the output gap. However, it should be observed that, given the undervalued currency, maintaining the peg leads eventually to above trend NGDP growth and an economy that's running "hot". However, the "hot" economy would call the currency peg into question. This is a classic example of Mundell's policy trilemma. The SNB cannot pursue an exchange rate peg, independent monetary policy, and capital mobility at the same time. Conditions are stable now only because the exchange rate peg matches the objective of an independent monetary policy. However, once the output gap starts to narrow the credibility of the exchange rate peg will be questioned.

This is where the expectations channel starts creating weird dynamics. If the market expects the SNB to pursue monetary policy that prioritizes internal conditions, then the market should expect that currency to appreciate in the future as the output gap is filled. However, because of inertial central bank policy, this will only occur when the currency is undervalued to such an extent that it is no longer feasible for the central bank to maintain the peg. At that point, we should expect to see a very sudden adjustment as the SNB comes under fire from speculators. This then creates a vicious loop, as the SNB's attempts to maintain the peg only increase the supply of currency, of which speculators buy increasing amounts as they now know that the currency will appreciate.

When the SNB is forced to rebalance the currency, it will shake up markets as it unwinds its large balance sheet of foreign assets. Since the bank would have been accumulating these assets for a long time, their sudden liquidation is likely to be a "fat tail" event, which, on one hand may not cause that much damage, but on the other hand may cause positive feedback loops to devastate markets in unknown ways.

While this analysis is in the specific context of the Swiss central bank, this argument has implications for NGDP targeting in developing countries as well. The problem with the SNB's currency peg is that it prioritizes one objective (exchange rate) over all others (including NGDP). However, when domestic politics rears its head, a internal measures such as NGDP will end up trumping external measures such as the exchange rate. The crisis arises from a sudden reversal in priorities.

This exchange rate-NGDP tension is very important for developing economies. If these countries pursue capital mobility, then they may need to compromise part of their monetary policy to maintain an exchange rate band. Thus, this is another source of possible fragility in a NGDP target, as other objectives, such as the exchange rate, suddenly come to the forefront.

Edit: Evan Soltas gave me a further explanation on how the "peg" is really a floor, as well as an explanation of the general macro conditions in Switzerland. I failed to take the time to analyze them, so the conclusions are slightly different. There's still possibilities of non-linear dynamics, and those are explained in the comment thread. I've also written a new post reflecting back of these issues here.


  1. Lulu,

    I think you need to keep in mind what the Swiss are going through. The currency is massively, massively overvalued from a purchasing power parity standpoint; this is all driven by capital inflow. They're seeing slight core and headline deflation in their CPI numbers. While I don't like exchange-rate targeting regimes either, it's important to remember that this is what properly accommodative policy would look like in a country like Switzerland, when it has exhausted the interest rate channel. When the capital inflow pressures stop, the Swiss franc will depreciate significantly, and the floor will become irrelevant and be scrapped, as I wrote in my post. This is a bid by the SNB to lessen the consequences of financial tremors in Europe on their domestic macroeconomic conditions.

    This is all to say that, respectfully, I don't buy your "Extremistan Is Coming" argument here. It's an exchange rate FLOOR against the Euro, not a peg, so the Swiss franc can depreciate -- which is what the SNB wants to see happen. There's no way forex traders or financial pressures could outdo the power of the central bank printing press, period. I think it's much more likely that we'll rest at the 1.20 EURCHF rate for perhaps a few years, I don't know, and then if/when Europe heals we'll see that rate rise on its own accord, slowly, driven by PPP-related pressures. You seem, frankly, do be under the incorrect impression that the Swiss franc is undervalued, and that the intervention is keeping it artificially so. That's not the case -- this is a temporary capital market pressure making worse an underlying overvaluation. Therefore the end of the floor will come in depreciation, not in an appreciation breakthrough down below the floor. Moreover, when the floor becomes disaligned with independent monetary policy, they'll scrap the floor -- that's because the only situation in which these two interests conflict is the one Switzerland wants to see happen...a return of low and controlled inflation and the valuation of the currency at proper levels.

    I think that your analysis is much more appropriate for the reverse situation, in which a central bank must maintain a currency band against devaluative pressures. India is very much in that situation, even though the rupee is perhaps the most undervalued currency right now by a PPP standpoint. The Indian central bank is struggling to hold up the exchange rate of the rupee to prevent inflation, particularly in fuel and food, which is already bad. It's not a credible effort on their part because such a strategy -- an exchange rate ceiling -- requires selling, and in India's case exhausting, one's foreign reserves.

    - Evan Soltas

  2. Evan,

    I think we are both in agreement that depreciating a currency is a valid way to implement expansionary monetary policy, and that the floor on the exchange rate is only going to stay to the extent that it is a stabilizing force on domestic aggregates such as NGDP or inflation.

    However, I don't think the fact that a currency floor limits the fragility in the system. While the Swiss bank has been very successful in controlling the price of the Franc relative to the Euro, we need to stay aware of the fact that the bank can't simultaneously control the quantity of Francs in the market, or, more importantly, the large size of the assets denominated in other currencies ( The floor conceals any volatility in the value of the currency in the context of the financial crisis. You can imagine this as a highly volatile graph moving below the 1.20 floor. As a result, although the markets might have shifting expectations, the rate is still held at 1.20. However, once the market expects a depreciated currency, there would be a sudden burst of volatility that "pops" out of the flat line at 1.20. The worrisome part of this is that, with so many assets already purchased, a slight change in the price of the Franc may cause large amounts of turmoil on global markets. At its core, the exchange rate floor takes information away, preventing true analysis of whether the floor is tenable.

    As to solutions for this problem, it would be much more helpful to target ANY level of exchange rate that would also satisfy the stable inflation rate target. This would allow higher levels of volatility in the exchange rate as long as they don't interfere with stable NGDP growth. This would remove the "critical point" value of 1.2 that might lead to large jumps. A possible extremistan regime is the only one possible, as there are no more gaussian vibrations that could make it a type-1 regime. As a result, if capital flows back of as you suggest, the shift will be very sudden for the country.

    One last more philosophical note: when I look at extremistan/mediocristan, I try to stay away from evaluating probabilities. It is very difficult to try to estimate the probability that something will happen, because small probability events are impossible to measure. However, we can evaluate if something is fragile without knowledge of the probability of it breaking. We know it's fragile because of some core structural features. As a result, I don't find your "extremistan is not likely" argument that convincing

    -Yichuan Wang