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Monetary policy report 2005

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Four times a year – in mid-March, June, September and December – the National Bank’s Governing Board conducts a regular assessment of the monetary policy situation. Each of these assessments results in an interest rate decision. If circumstances so require, the National Bank also adjusts the Libor target range for three-month investments in Swiss francs between regular assessment dates. In 2005, however, this was not the case.

Monetary policy challenge in 2005

Despite the decision taken on 15 December to raise the three-month Libor by 25 basis points, monetary policy remained expansionary throughout 2005. The normalisation of interest rates that began in summer and autumn of 2004 was suspended in 2005. On many occasions the National Bank had indicated that the interruption in interest rate increases, maintained since December 2004, would only be temporary. However, the major challenge in 2005 was to determine the moment when the interest rate should be lifted again.

Temporary stability...

The first signs of a vigorous recovery in the Swiss economy were already evident in spring 2004, when the National Bank initiated the process of raising its interest rates. However, the upswing faltered at the end of 2004 and economic activity grew only hesitantly in the first half of 2005. In view of a global economy rendered erratic and unpredictable due – in particular – to the listless economy in Europe and the record levels of oil prices, growth forecasts for Switzerland were adjusted downwards during the course of 2005. The slowdown, while linked to a favourable inflation outlook, caused the National Bank to maintain the Libor at the level of September 2004 throughout the first three quarters of 2005.

… and increase in Libor in December

The National Bank raised its interest rates in December, at the final monetary policy assessment of the year. By making this one-year break, the SNB had demonstrated its flexibility. Taking account of the declining long-term inflation risks, it had utilised the greater degree of leeway available to it for maintaining an expansionary monetary policy. Nevertheless, it had monitored developments carefully throughout the year, as is evident in the monetary policy assessments undertaken in March, June and in particular September. It acted promptly once the indications of a robust and sustained economic recovery had finally consolidated.

Monetary policy risks in 2005

As in previous years, monetary policy in 2005 was subject to numerous short, medium and long-term risks. The probability of such risks occurring, their consequences for the economy and their impact on monetary policy are analysed regularly by the National Bank.

… in the long term

The low interest rate of the past three years was incompatible with a recovering economy. The inflation forecasts made in 2005 clearly showed that medium and long-term price stability could not be guaranteed at the interest rates prevailing in the year under review. It was evident, therefore, that the normalisation initiated in 2004 had not been concluded; an excessively long interruption in this process would have entailed a substantial inflation risk. The National Bank’s awareness of these interconnections led to the interest-rate decision in December.

… in the medium term

In the medium term, the biggest risk was posed by the many uncertainties associated with the economic situation in the world and in Switzerland. The US economy maintained a strong rate of growth despite the environmental disasters experienced in the southern states. However, in Europe, the situation was unsatisfactory since domestic demand was slow in picking up. Moreover, it was considered possible throughout 2005 that the global economy might pursue a different course. Switzerland’s growth engines – investments and exports – are largely dependent on international conditions. Consequently, there was considerable uncertainty with regard to economic developments in Switzerland in 2005, and this created additional difficulties when deciding on the timing for a resumption of normalisation.

… and in the short term

In the short term, oil price fluctuations were again the focus of attention. There were no further inflation risks. Oil prices persisted at a high level, but there were no significant second-round effects. On the one hand, the high oil prices had a dampening effect on demand and growth (even if this effect was limited), while on the other hand, strong competition in numerous markets helped to moderate price and wage developments, thereby reducing the risk of spiralling inflation. Even though the situation was worrying, it did not require the National Bank to take any special action during the course of 2005.

Initial situation: final quarterly assessment in 2004

The National Bank’s inflation forecast on 16 December 2004 was based on a Libor of 0.75%. At that time, the SNB forecast annual inflation of 1.1% for 2005, taking account of an increase in oil prices as well as a higher valuation of the Swiss franc against the dollar. The stronger Swiss franc meant a tightening in monetary conditions and thus a lower inflationary impact from the increase in oil prices. For 2006 – in the medium term – the SNB now predicted a lower inflation rate of 1.3% averaged out over the year and 2% at the end of the year. This adjustment to the previous quarterly assessment was due to the expectation that the closure of the output gap would be delayed. In the longer term, finally, the forecast reflected lower inflationary pressure than had been assumed for the same period during the course of 2004. The easing in the situation was mainly due to the absorption of the liquidity surplus that had begun in summer 2004.

After raising the Libor twice, in June and September 2004, the Governing Board decided in December to leave the target range unchanged at 0.25–1.25%, and to keep the Libor at 0.75%. Since inflationary pressure was expected to lessen, the National Bank did not see any need to take a further step towards the normalisation of interest rates. Apart from these considerations, monetary conditions were already tighter because of a stronger Swiss franc. Despite this, monetary policy at the beginning of 2005 remained expansionary. The National Bank nevertheless noted that, in view of the inflation anticipated in the long term, the normalisation of interest rates begun in mid-2004 had not been completed.

Quarterly assessment of 17 March 2005

At each monetary policy assessment, the National Bank bases its inflation forecast on the global economic scenario it regards as most likely. In the quarter preceding the March 2005 assessment, the US economy was strong and broad-based, giving rise to expectations that this would continue in the following quarters of 2005, with an annual growth rate of 3.4% for 2005. In the European Union, by contrast, growth rates in the final two quarters of 2004 were below expectations. The recovery during the course of 2005 foreseen in the scenario of December 2004 was still anticipated, although it would be a little delayed. For 2005, the National Bank forecast about 1.9% growth in Europe. With a renewed increase in fossil fuel prices, it predicted that prices would remain high for the next few quarters.

For Switzerland, the National Bank forecast real GDP growth of about 1.5% in 2005, as compared with 1.5–2.0% in the September 2004 assessment. Even though it might be modest, a continuation of economic recovery was linked with the foreseeable stimulus provided by exports and investments. Renewed strength was also evident for 2005 in private consumption, which had slowed markedly in 2004. However, the SNB did not expect that production capacity would be fully utilised until the second half of 2006. With respect to monetary aggregates, there was a drop in M1 and M2, while M3 grew only slightly. Aware that its monetary policy was still expansionary, the National Bank paid particular attention to the real estate sector and in particular to the rapid and continuous rise in mortgage lending.

The inflation forecast published in March 2005 was based on a Libor of 0.75% and showed consistently lower rates of inflation than the December 2004 forecast. At 0.7%, forecast inflation would have reached its low point in the fourth quarter of 2005. The expectation of a marked decline in the rate of inflation right through the year was essentially the result of a statistical effect. On average, inflation would amount to 1% for the year. In the medium term, from 2006, it was likely to creep up because of higher utilisation of production capacity. An inflation rate of 2.6% was expected for the end of 2007. Consequently, at the end of the forecast period the 2% mark – the upper limit of the range the National Bank equates with price stability – would have been clearly exceeded. On the basis of the inflation forecast, therefore, it was clear that the rate of interest could not remain unchanged in the long term, and that it would be raised by the SNB when the production gap began to close.

Despite this situation, the Governing Board decided to leave the target range for the three-month Libor unchanged at 0.25–1.25%. The reasons for this decision were two-fold. First, inflation prospects had improved slightly since the last monetary policy assessment on 16 December 2004. As a result, there was more leeway for monetary policy action. Second, the National Bank had lowered its forecast for the Swiss economy. In addition, there had been disturbing developments in a number of possible scenarios since the December assessment. For instance, the persistence of high oil prices could have held back the global economy more severely than had been assumed.

By leaving the target range for the three-month Libor unchanged, the National Bank maintained its expansionary monetary policy. It made use of the monetary policy leeway available to it in order to support the economic recovery, but without jeopardising medium and long-term price stability.

Graph Inflation forecast Q1 2005

Quarterly assessment of 16 June 2005

Since the beginning of the year, repeated increases in the price of oil had put a brake on the global economy. The situation was particularly unsatisfactory in Europe because, in addition to expensive oil, the rise in the value of the euro in the fourth quarter of 2004 was also curbing economic activity. Consequently, the National Bank lowered its growth assumptions for Europe to 1.5% for 2005 and 2.1% for 2006. By contrast, the US economy seemed to be only mildly affected by the difficulties in the oil markets and growth estimates there were maintained at 3.4% for 2005 and 3.6% for 2006.

As usual, international conditions had a strong impact on the Swiss economy. Contrary to the expectations of the National Bank at its previous monetary policy assessment, economic activity in Switzerland remained sluggish in the first quarter of 2005. Real GDP was unchanged from the previous quarter, although domestic demand increased slightly. This disappointing result was mainly attributable to weak exports and investments. In view of the low level of demand, companies curtailed investment, and this, in its turn, affected employment. The uncertain labour market situation had a dampening impact on consumer spending. Although private consumption rose, the rate of increase was below the historical average.

In these circumstances, the Swiss economy could no longer be ex-pected to grow by approximately 1.5% in 2005, as forecast by the National Bank in March. Consequently, the forecast for real GDP growth in 2005 was adjusted down to about 1% at the June assessment. Assuming that exports recovered, the National Bank was still expecting the economy to record a moderate improvement over the course of the year.

The incentive for consumers and producers to hold liquid investments remained strong due to the persistence of a low interest rate. In the view of the SNB, there was still an excess of liquidity in the economy. Although the M3 monetary aggregate was still rising slightly, excess liquidity was no longer increasing. Financial conditions remained favourable in real estate. Mortgage lending had risen by an average of over 5% a year since the beginning of 2003, and even though mortgages granted to private households had slowed towards the end of 2004, the rate of growth still exceeded that of previous years. Since the beginning of 2005, corporate mortgage lending had also increased, after having declined in the five previous years.

The SNB did not change its inflation forecast for 2005 from that published at the March assessment, continuing to expect a 1% increase in prices for the year. The projected decline in the rate of inflation over the course of the year was attributable to the assumed stabilisation in the oil price. At the June assessment, inflation levels for the period after the end of 2005 were expected to be substantially lower than those forecast in March. Given a Libor of 0.75%, inflation for 2006 was forecast at 0.5% and for 2007 at 1.4%. Consequently, the medium-term inflation outlook was more positive than at the previous monetary policy assessment (2006: 1%, 2007: 2.1%). The expected low level of inflation for 2006 was attributable to the fact that the economy was likely to be sluggish. For 2007, however, the rate of inflation was set to increase faster as a result of better utilisation of production capacity and a high level of liquidity. At the end of the forecast period, inflation would reach 2.4%. As at the previous monetary policy assessment, the outer limit of the range which the National Bank equates with price stability would have been exceeded. However, the amount by which this limit was exceeded would not have been quite as great due to the fact that the liquidity surplus was gradually receding.

Once again, the Governing Board decided to leave the target range for the three-month Libor unchanged at 0.25–1.25%. The reasons for this decision were three-fold. First, the National Bank had lowered its forecast for the Swiss economy. Second, the medium-term inflation outlook associated with this slow economic development was improved, and an increase in the target range for the three-month Libor appeared less urgent. Third, there was more uncertainty with regard to international developments. It was harder to judge the economic outlook for Europe than it had been in March 2005. While oil prices had dropped in April and May, they had risen again in June and there was a risk of them persisting at a high level for a long period to come. In addition, the decline in long-term interest rates observed in numerous international markets was difficult to reconcile with a recovery in the economy.

By leaving the Libor unchanged, the National Bank maintained the monetary policy course pursued up to then. It continued to use the available leeway to support the economy without jeopardising medium and long-term price stability.

Graph Inflation forecast Q2 2005

Quarterly assessment of 15 September 2005

In the previous monetary policy assessment, the SNB had assumed that, although the price of oil would remain high, it would gradually edge downwards. However, contrary to this assumption, oil prices had continued to rise sharply. Consequently, the forecast drawn up in September was based on a very high price for oil. This would be even more detrimental to the recovery in Europe, and the growth forecast for 2005 was cut back to 1.4%, while that for 2006 fell to 2%. In the US, by contrast, the rise in oil prices was more than compensated by other factors, in particular the high level of consumption. For this reason, the SNB was a little more optimistic about US growth than in June, and adjusted its forecasts upwards for 2005 and 2006, to 3.6% for both years.

For Switzerland, the National Bank was still forecasting real GDP growth of about 1% in 2005. Both investments and private consumption had already picked up before September. Growth was now broader-based, and a continuation of this trend appeared probable for the second half of 2005. It was assumed that exports and construction would provide the major impetus, while consumption continued to suffer from the high oil prices and the persistence of unemployment. The economic recovery expected in 2006 would bring with it an improvement in the labour market, and thus also stronger growth in consumption in the medium term. Full utilisation of production capacity was likely to be achieved towards the end of 2006.

The M1 and M2 monetary aggregates were no longer receding, while M3 was advancing at an even faster rate. Although the supply of liquidity to the economy remained abundant, it did not present any direct threat to price stability. Mortgage lending in the real estate market continued to grow strongly.

Due to the high oil prices, the rate of inflation forecast for the period to mid-2006 was higher in September than it had been in June. A high level of inflation was expected to persist for a number of quarters. It could be assumed that the increase in oil prices would not trigger spiralling inflation since it was probable that the level of economic activity would be relatively moderate and the recovery in the labour market very slow. However, in view of the recent developments in oil prices, the National Bank revised upwards its forecast of average inflation for the year 2005 to 1.2%. Assuming a stabilisation in oil prices, it forecast that inflation would recede in the first half of 2006, due to a statistical effect. Thereafter, given full utilisation of production capacity and a persistently high level of liquidity, higher rates of inflation could be expected from the end of 2006. At 0.8%, average inflation for 2006 was slightly higher than at the previous assessment, while the 2007 figure was unchanged at 1.4%. By the end of the forecast period, inflation would amount to 2.6%, still above the limit of the range that the SNB equates with price stability.

The National Bank decided to leave the target range for the three-month Libor unchanged at 0.25–1.25% and to maintain its expansionary monetary policy course. There were two factors that gave rise to this deci-sion. First, the curve for projected inflation remained low until mid-2006, despite the fact that, in real terms, oil prices had reached the highest level for twenty years. This afforded the National Bank a certain amount of leeway which it could use without jeopardising price stability.

Second, there was a degree of uncertainty with regard to the development of economic activity in Switzerland. Nevertheless, a growth rate of 1% for 2005 could be assumed, as at the previous monetary policy assessment. Consequently, the National Bank decided to maintain the level of interest rates, while also making it clear that, as soon as the recovery in the economy was confirmed, it would change the monetary policy course which had been expansionary for a long time.

Graph Inflation forecast Q3 2005

Quarterly assessment of 15 December 2005

Although the growth forecasts for the euro area and the US were almost unchanged from the September monetary policy assessment, the SNB expressed confidence on the outlook for the global economy. For 2005, it continued to work on the basis of a European growth rate of 1.4%, and for 2006, 2%, while its growth assumptions for the US were lowered slightly, to 3.5% for 2005 and 3.6% for 2006. In view of the vitality of the US economy, the National Bank forecast growth of about 3.5% in 2007. The SNB was also optimistic about developments in the euro area, projecting a growth rate of 2.4% in 2007. As compared to the situation at the previous monetary policy assessment, world oil markets had eased somewhat. Consequently, the National Bank no longer regarded oil prices as having the potential to hold back the industrialised economies, although it assumed that the price level would remain high over the next few quarters.

Unlike the September monetary policy assessment, when the SNB was still expecting the Swiss economy to grow by only 1% in 2005, at the December assessment it revised its forecast upwards to just over 1.5%. First, seco’s revised GDP growth rates for the first two quarters supported a more optimistic evaluation. Second, both consumption and equipment investment were strong in the third quarter, and positive developments could be expected in the next few quarters. This scenario would not be affected by the levelling off in construction investment expected in 2006. Economic activity at the end of the year was a further factor supporting the National Bank’s confidence in the outlook for 2006. Given this situation, the SNB forecast GDP growth of a little more than 2%.

Monetary indicators also pointed to an improvement in the economic situation. The trends that had emerged at the September assessment were further reinforced shortly before the December assessment. There was an additional acceleration in the movement of the M1 and M2 aggregates that had persisted since August. M3 grew even more strongly. In October 2004, its rate of growth was just 1%, while at the monetary policy assessment it came to more than 6%. The SNB also devoted special attention to real estate, an area which remained very active.

As at the previous monetary policy assessment, the National Bank forecast inflation of 1.2% for 2005. On the assumption of an unchanged Libor of 0.75% in the following three years, the December forecast for inflation in 2006 was revised upwards from the rate forecast at the September assessment. By the end of the forecast period, inflation would amount to 3%, considerably above the limit of the range that the SNB equates with price stability.

Given this situation, the Governing Board decided to increase the target range for the three-month Libor by 25 basis points, to 0.50–1.50%, and to hold the Libor in the middle of the target range for the time being. At the beginning of the year, with the considerable improvement in the medium and long-term inflation outlook, the National Bank had suspended the normalisation of its interest rates. At the monetary policy assessment in September 2005, it had again decided against increasing the interest rate. While the improvement in the inflation outlook appeared to be petering out, a sudden rise in the oil price created uncertainty with respect to economic prospects. In December, the need for action became more urgent with the upturn in the global and Swiss economies. As a result, the SNB resumed normalisation of its monetary policy course.

Assuming an unchanged three-month Libor of 1% for the next three years, the Governing Board forecast annual inflation of 0.8% in 2006, 1.2% in 2007 and 2.7% for the end of the forecast period. This would still be above the limit of the range that the National Bank equates with stability. Thus, monetary policy remained expansionary and continued to support economic recovery.

Graph Inflation forecast Q4 2005