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Monetary policy decisions 2006

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On 21 February 2007, the Governing Board of the Swiss National Bank submitted its 2006 Accountability Report to the Federal Assembly in accordance with art. 7 para. 2 of the National Bank Act. The following Accountability Report is submitted to the Federal Council and the General Meeting of Shareholders for information purposes only, and does not require their approval.

Monetary policy challenges in 2006

In 2005, the SNB had demonstrated its flexibility by pausing temporarily in the normalisation of its monetary policy course. With long-term inflation risks declining, it was able to make use of the available leeway for further pursuing its expansionary policy. By December 2005, the indications of a robust and sustained recovery had become so clear that the National Bank resumed normalisation of its monetary policy. There was no doubt that this course would need to be pursued in 2006; the inflation forecasts of the final monetary assessments in 2005 had made this abundantly clear. However, it was the magnitude and frequency of these interest rate increases which constituted the principal challenges of monetary policy in 2006.

Four increases in the Libor target range

In 2006, the SNB raised its target interest rate on four occasions, by 25 basis points each time. This took the Libor to 2% by the end of the year. The National Bank pursued its policy of normalising interest rates through moderate increases, carried out at regular intervals, an approach which should ensure price stability in the medium and long term while also taking the best possible account of economic reality. Despite the rise in oil prices in mid-2006, the economic and inflationary perspectives developed evenly, thereby allowing the SNB to gradually tighten the monetary policy reins.

Monetary policy risks in 2006

As in previous years, monetary policy in 2006 was subject to numerous risks in the short, medium and long term. The National Bank regularly evaluates the probability of such risks, their consequences for the economy and their implications for monetary policy.

Short-term risks

The vagaries of oil prices represented the chief short-term risk in 2006. However, the volatility in energy prices did not induce the SNB to take any special measures. On the one hand, it would have been inappropriate to act against the inflationary effects of higher oil prices, since a tightening in monetary policy could have added force to the moderating impact of increased oil prices on the economy. On the other hand, since there was no reason to fear a greater slowdown, it would also have been wrong to intervene by lowering interest rates.

Medium-term risks

Uncertainties with respect to the global and Swiss economies remain the principal risks in the medium term. Neither Europe nor Switzerland gave rise to any major concern in 2006. However, there were repeated indications, particularly in the second part of the year, that the US economy might be facing a more substantial slowdown in the future. This kind of scenario represented a major risk to the economic situation since investment and exports are largely dependant on international conditions. Furthermore, the appreciation of the euro against the Swiss franc – in particular at the end of the year – created an additional risk which the SNB needed to keep a careful eye on.

Long-term risks

The outlook for inflation in the medium and long term would have deteriorated if the SNB had not resumed the normalisation of its monetary policy and continued on this path in 2006. Thus, raising the rate of interest was necessary if favourable perspectives for price stability were to be preserved.

Starting point: the final quarterly assessment of 2005

At its quarterly assessment of 15 December 2005, the National Bank had been confident about the outlook for the global economy. With the US economy continuing to show signs of vitality as it moved into the new year, the SNB had forecast growth of approximately 3.5% for both 2006 and 2007. It had also been optimistic for the euro area, predicting growth of 2% for 2006 and 2.4% for 2007. It had expected the price of oil to be high in the upcoming quarters.

Based on the state of the Swiss economy at the end of 2005, the SNB had been confident about developments in 2006 and forecast growth of just over 2%. Consumption and equipment investment had been relatively robust in the third quarter of 2005, and positive developments could be expected over the next few quarters.

As compared to the September assessment, the inflation outlook had been adjusted upwards. In these circumstances, the Governing Board had decided to lift the three-month Libor target range by 25 basis points in December 2005. The new range had been set at 0.5–1.5%. At the beginning of 2005, the SNB had initiated a break in the process of normalising its target interest rate. In view of the economic upswing expected for 2006, it had then resumed normalisation of this interest rate at the end of 2005.

Under the new assumption, which saw the Libor at a constant 1% for the three following years, inflation – according to the graph published at the time of the assessment (cf. 98th Annual Report 2005, p.36) – had been forecast to rise to 0.8% in 2006 and to 1.2% in 2007. By the end of the forecast period, inflation had been expected to rise to 2.7%, thereby exceeding the upper limit of the range which the SNB equates with price stability.

Quarterly assessment of 16 March 2006

At each monetary policy assessment, the SNB bases its inflation forecast on the global economic scenario it regards as most likely.

In general, the hypotheses for the global economy at the first assessment in 2006 were similar to those of December 2005. Once again, the SNB forecast a robust global economy. Although-fourth quarter GDP growth in the US in 2005 had failed to meet the expectations of the previous assessment, the SNB still forecast strong growth for 2006, predicting a rise of over 3%. In the euro area, economic growth was shaping up more favourably than had been expected in the previous forecast. Consequently, the SNB forecast growth of approximately 2.5% for 2006. With regard to oil, it continued to work on the basis of high prices for the quarters ahead.

Since, at the time of the March assessment, the Swiss economy was progressing as expected, the SNB continued to forecast GDP growth of a little above 2%, as it had done in December 2005. The economy was likely to gain a little more strength and become even more broad-based. Thanks to the favourable development in sales in the main export countries, exports were likely to continue growing, albeit at a less buoyant pace. The higher level of capacity utilisation in manufacturing would probably again stimulate investment and increase demand for equipment. Only construction was expected to weaken a little, given its high level. An upturn in consumption and an improvement in the labour market were also likely.

Monetary aggregates react rapidly and clearly to interest rate decisions. Consequently, growth in the aggregates slackened following the rate increases in 2004 and December 2005. The money overhang generated during the period of extremely expansionary monetary policy stopped advancing after the interest rate hikes, while the growth in the volume of loans stabilised at a relatively high level. Furthermore, the SNB continued monitoring movements in the real estate market, in particular mortgage loans, which were still climbing at a rate of over 5%.

At the time of the March assessment, the increase in prices was mainly attributable to the price of oil. At that time, the SNB was forecasting an average annual rate of inflation of 1% for 2006. As compared to the December assessment, the inflation outlook was adjusted upwards. In these circumstances, the Governing Board decided to lift the Libor target range by 25 basis points to 0.75–1.75%.

Assuming that the new Libor was maintained unchanged at 1.25% for the following three years, the SNB forecast inflation to be higher than that predicted at the previous assessment until the end of 2006, as can be seen from the graph published at the time of the March assessment. The assumption of a high price for oil and the slight increase which was shaping up for the prices of imported goods contributed to this inflationary pressure in the early part of the forecast period. For the period 2007–2008, however, the new forecast showed a lower path than the previous forecast. At the end of the forecast period, expected inflation again exceeded the upper limit which the SNB equates with price stability.

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Quarterly assessment of 15 June 2006

At the time of the June assessment, the international environment was little changed from the situation at the previous assessment. For the US, the SNB expected that GDP growth could once again exceed potential in 2006, although it would then weaken gradually. Similarly, the recovery observed in Europe over the past few quarters would lead to growth above potential in 2006, flattening off gradually thereafter. With respect to oil prices, the National Bank assumed a higher price than that envisaged in March.

After having weakened in the fourth quarter of 2005, Swiss growth regained a certain amount of momentum in the first half of 2006. According to the State Secretariat for Economic Affairs (SECO), GDP was up 3.8% year-on-year in the first quarter of 2006. The SNB then revised its forecast for 2006 upwards to a little over 2.5%. Most components of demand were likely to bolster growth in the quarters following the assessment, particularly exports, which would probably continue to expand at a healthy pace. Due to the improvement in the labour market and a better income outlook, additional stimuli would probably feed into consumption. Since the recovery was broad-based, demand in the labour market was also likely to increase. For the first time in over a year, the number of employed persons in the services sector was up. At the time of the assessment, the rate of unemployment had fallen to 3.4%, and the SNB was expecting a continued decrease over the course of the year.

The M1 and M2 monetary aggregates were stabilising at the time of the monetary assessment, while M3 was only rising slightly. In the wake of economic developments the monetary overhang was likely to recede further. The effect of the higher interest rate had been negligible as far as loans were concerned. This was particularly noticeable in the case of mortgages, which continued to grow at a rate of about 5%.

As in March, inflation at the time of the June assessment was largely attributable to the high oil prices. The SNB forecast an average rate of inflation of 1.2% for 2006. As compared to the March assessment, the inflation outlook was adjusted upwards. In these circumstances, the SNB decided to lift the Libor target range by 25 basis points to 1–2%.

Assuming an unchanged three-month Libor of 1.5% for the subsequent three years, the SNB forecast inflation of 1.2% in 2007 and 1.9% in 2008. As compared to March, the inflation forecast for these two years remained largely unchanged, despite the moderating influence of the increased Libor. The main reason for this was the higher level of capacity utilisation in manufacturing. The inflation forecast also showed that there was no risk of inflation in the short term. However, the increase in the rate of inflation expected for the end of the forecast period indicated that monetary policy was still expansionary.

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Quarterly assessment of 14 September 2006

The situation in September was different to that in June in two respects. First, growth in the US economy was slowing more markedly than had been anticipated previously. However, the SNB still expected growth to reach 3% in 2007 and 3.2% in 2008. Second, recovery in the European economy was better than expected. Consequently, the outlook for 2007 and 2008 was likely to remain favourable with growth at around 2%.

Once again, economic developments in Switzerland were regarded as pleasing. The upswing was broad-based and was expected to have a positive impact on the labour market. Exports were likely to continue expanding, although they would probably lose a certain amount of their momentum. In addition, equipment investment was expected to continue rising, while the level of capacity utilisation in manufacturing was likely to remain high. In these circumstances, the SNB increased its growth forecast for 2006 to almost 3%, which was above the long-term average. In 2007, growth was likely to slow a little, although it would remain above potential.

Because of the gradual adjustment in interest rates, expansion in the monetary aggregates remained moderate. M3 was still increasing slightly, but M1 and M2 had exhibited negative growth rates in the months leading up to the assessment. In the real estate market, the SNB expected that the growth rate for mortgage loans would drop below the 5% level recorded at the time of the assessment. Despite the fact that the National Bank was anticipating a calmer period in the real estate market – signs of market weakening were already perceptible – it continued to keep a close watch on developments in this field.

The SNB forecast an average annual rate of inflation of 1.3% for 2006. However, it did not expect a rise in inflation in the quarters that followed. A number of factors combined to hold back price increases. These included competition from transition and emerging economies in Asia, the opening up of the Swiss employment market to foreign labour and the drop in the oil price at the time of the assessment. Nevertheless, on the assumption of an unchanged Libor of 1.5% for the next three years, the inflation outlook towards the end of the forecast horizon was likely to remain worrying. In these circumstances, the SNB decided to continue pursuing its policy course of gradually normalising the target rate of interest, and lifted the Libor target range by 25 basis points to 1.25–2.25%.

On the assumption of an unchanged new interest rate of 1.75% over the next three years, the path of the new inflation forecast lay above that for the previous assessment in June until the second quarter of 2007, despite the fact that the previous forecast was based on a lower interest rate. This new forecast was based, in particular, on the assumption that productive resources would be better utilised. For the remainder of the period, however, the inflation forecast was lower than the previous forecast, due to the moderating influence of the Libor. Taking this to be 1.75%, average annual inflation was likely to amount to 1.1% in 2007 and 1.6% in 2008. Thus, the inflation forecast showed that there was no inflationary risk in the short term. Nonetheless, the slight acceleration in inflation at the end of the forecast period indicated that monetary policy was still expansionary.

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Quarterly assessment of 14 December 2006

At the December assessment, the most important international development was the substantial decline in the price of oil. This drop halted an upward trend that had been almost unbroken since 2004. As a result, the National Bank forecast downward pressure on inflation in most economies over the next few quarters. The SNB did not believe that the impact on the global economy would be particularly great since oil prices were still high, in historical terms. Otherwise, the international economic trends observed in the previous assessment – a slowdown in the US and strong growth in Europe – were unchanged at the time of the December assessment. Consequently, the SNB forecast growth of 2.9% in the US and 2.3% in Europe in the year 2007, and 3.3% in the US and 2.2% in Europe in the year 2008.

As at the previous assessment, economic activity in Switzerland was assessed favourably. The effects of the economic upswing, which was broadbased, spilled over into the labour market, and the SNB expected the rate of unemployment to drop below 3% as early as the beginning of 2007. Again in 2007, all the components of demand would probably continue rising, although the rate of increase would be a little more restrained than had been expected in September. Consumption was likely to join exports and equipment investment (spurred by the high level of capacity utilisation in manufacturing) as one of the most important growth drivers in 2007. In these circumstances, the SNB confirmed its forecast of about 3% growth in 2006 and 2% in 2007.

Of the monetary aggregates, M3 expanded to about 2% at the time of the assessment, while M1 and M2 continued their downward trend. Clearly, movements in these aggregates were again being influenced by the interest rate increases. Growth in mortgage loans was below 5% at the end of the year, confirming expectations of a slowdown in their growth momentum. Therefore, the SNB was still anticipating a return to a period of greater calm in the real estate market. Based on movements in the monetary aggregates, the National Bank was also expecting a slowdown in other types of loan for the upcoming quarters, despite their liveliness at the time of the assessment.

The inflation outlook was good for the time being. Both oil price developments and the interest rate hikes were holding back price increases. Consequently, the National Bank lowered its average annual inflation forecast for 2006 slightly, to an average of 1.1%. Nevertheless, the SNB decided to continue its gradual normalisation of the target rate of interest, and lifted the Libor target range by 25 basis points to 1.50–2.50%. In doing so, its aim was to avoid excessive use of resources in the years 2007 and 2008, thereby exercising a moderating influence on inflation in the medium term.

The curve for the new inflation forecast, drawn up on the assumption of an unchanged Libor of 2% over the next three years, was well below that published in September. This change was attributable mainly to the new, higher level of the Libor, but also to the drop in oil prices. Average inflation was expected to amount to 0.4% in 2007 and just under 1% in 2008. Thus, the inflation forecast showed that there was no inflationary risk in the short term. However, towards the end of the forecast period the inflation curve showed a clear upward trend. This reflected the fact that monetary policy was still expansionary in view of the expected development of the Swiss economy.

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