My biggest frustration over the past decade is how often I see economists misdiagnose the stance of monetary policy, either reasoning from price changes or reasoning from quantity changes. The “reason from a price change” problem has been discussed extensively in this blog, so today I’ll focus on reasoning from a quantity change.

Many economists assume that a country that has done extensive QE has, ipso facto, adopted an expansionary monetary policy. That is certainly true in some cases, but in other cases the QE is a defensive move, an endogenous response to previous tight money policies that drove nominal interest rates to zero and money demand to very high levels.

Thus I was very pleased when David Beckworth directed me to an article that gets the causation right. The article is by Daniel Kaufmann, with the following subtitle:

This is Part 5 of a series of articles on Swiss monetary policy I wrote jointly with Simon Schmid for Republik. They kindly agreed that I can publish an english version on my blog.

Much like Japan, Switzerland has seen extremely low inflation “despite” the fact that their central bank’s balance sheet has ballooned to more than 100% of GDP.  I put scare quotes around ‘despite’, because it would be more accurate to say that the balance sheet has ballooned “because” of very low inflation.  Here’s Kaufmann:

The crucial point is, however, that the appreciation is not merely caused by exogenous foreign factors but can be partly traced back to the SNB’s monetary strategy and mandate. The low inflation target reduces the scope for interest rate cuts and therefore amplifies appreciation pressures in crises.

Small interest rate cuts and large balance sheet expansions

In other words, there is a connection between the Swiss definition of price stability and the large foreign exchange interventions by the SNB.

I generally explain this in a simpler way.  Low inflation leads to low nominal interest rates via the Fisher effect.  And low interest rates boost the real demand for base money.  Kaufmann’s explanation is more detailed and will probably be more persuasive to mainstream economists, as he focuses on how Switzerland’s low inflation target leaves it with less room to cut rates in a recession, and hence it must substitute massive QE to prevent the sort of currency appreciation that would otherwise drive Switzerland into deflation.

He then discusses some alternatives to having a bloated balance sheet:

The first kind, uses changes in the composition or size of the balance sheet to affect financial markets. The main idea is that financial markets are inefficient (or subject to substantial transaction costs) and the central bank can correct distortions through direct interventions in particular markets (for example in the mortgage market or in the foreign exchange market).
The second kind, affects expectations of market participants about future monetary policy. A central bank can, for example, promise to defend a foreign exchange peg in order to increase future inflation.

Another option is price level targeting.

In the past, I’ve argued that the Swiss made a mistake in January 2015 when they abandoned their exchange rate peg to the euro.  They seem to have been partly motivated by a desire to avoid having to buy up lots of foreign assets to defend the peg, but in the long run the appreciation of the Swiss franc merely pushed inflation in Switzerland even lower, making the SF an even more attractive asset for foreign speculators.

I wish my fellow economists would internalize this message.  It is dangerous to draw policy conclusions from big central bank balance sheets, for exactly the same reason that it is dangerous to draw policy conclusions from very low nominal interest rates.  Both variables are a mix of exogenous policy tools and endogenous responses to previous policy decisions.  To see them only as policy tools is to miss the more important part of the picture.

PS.  Switzerland may seem like a small and unimportant country, but the message here also has important implications for Japan and the Eurozone.

PPS.  David Beckworth recently interviewed me on what I am now calling the “Princeton School” of macroeconomics.  I plan to write a paper on this topic.