Canada’s inflation has been on the rise since early 2021. Year-over-year, CPI inflation went from 1.1 per cent in January 2021 to 4.8 per cent in December to a peak of 8.1 per cent in June 2022. Since then, it has followed a descending path, falling to 7.0 per cent in August — yet a level 3.5 times higher than the official 2.0 per cent target.
This upward inflationary trend is not, however, exclusively a Canadian experience. U.S. inflation, for instance, has followed a similar path: it increased from 1.4 per cent in January 2021 to a peak of 9.1 per cent in June 2022, before falling to 8.3 per cent in August.
The situation has also been fairly similar on the other side of the Atlantic. For instance, Germany’s inflation rose from 1.0 per cent in January 2021 to 7.9 per cent last August, while that of the U.K. increased from 0.9 to 8.6 per cent during that same period. For the 27 EU countries, average inflation rose from 1.2 per cent in January 2021 to 10.1 per cent in August 2022, while for the 19 eurozone countries the hike was from 0.9 to 9.1 per cent.
So, definitely, rising inflation is a global phenomenon. Therefore, it appears there must be some common factors simultaneously affecting inflation in all these countries. In this regard, most analysts agree these common factors include the initial supply-chain bottlenecks spurred by the pandemic, the subsequent strong recovery of the world demand for oil and other commodities, and more recently the war in Ukraine. These are all international factors affecting every country’s inflation — that is, these factors are responsible for the “imported” component of a country’s inflation.
Yet, while most countries have certainly faced significant increases in inflation since early 2021, Switzerland stands out as a rare exception. As a starter, when most countries began experiencing rapid rising inflation, Switzerland was instead concerned with deflation. In addition, while also following an ascending path, Swiss inflation remained lower than in all countries except Japan. Indeed, Switzerland’s rising inflation peaked at 3.5 per cent this August — less than half of Canada’s peak — and then decreased to 3.3 per cent in September.
Hence, it seems useful to examine why, in a world of generalized high inflation, Switzerland inflation has stayed so low. More precisely, what lessons can we learn from Switzerland’s experience with inflation?
Unquestionably, imported inflation appears as the main determinant of today’s overall inflation. On a year-over-year basis, Swiss prices of imported products increased 8.6 per cent in August, while prices of domestic products rose only 1.2 per cent. Canada, the hike in the average price of imported products was much higher at 12.9 per cent.
So, how has Switzerland managed to ease the impact of imported inflation to this extent? Well, although no outcome is the result of just one factor, the strength of the Swiss franc appears to have played a significant role here.
Since the start of the Great Recession in 2008, Switzerland’s status as a haven economy has compelled the Swiss National Bank (SNB) to curb the inflow of capital to lessen the upward pressure on the Swiss franc and maintain the competitiveness of the country’s exports. Thus, the SNB repeatedly reduced the policy rate to the extent of introducing negative rates in January 2015. The objective was to maintain a “fair” or “competitive” exchange rate of 1.2 Swiss franc to the euro (or, equivalently, of 0.83 euro to the Swiss franc). This turned out to be unattainable due to the ECB and other central banks also reducing their policy rates, leading to renewed upward pressure on the franc. Consequently, the value of the Swiss franc has fluctuated around 0.91 euro — around 10 per cent above target — until the second quarter of 2022. However, notwithstanding this alleged “overvaluation” of the franc, Switzerland has enjoyed strong surpluses in its current account, which combined with small deficits in the capital account, have translated into healthy overall balance of payment surpluses every year — thus putting into question the supposedly overvaluation of the franc.
One critical point where SNB monetary policy has contrasted with most other advanced economies’ central banks: until recently, its objective has been to achieve “exchange rate stability” rather than “price stability.” As a matter of fact, Swiss inflation has never been an issue, remaining most of the time below one per cent until late 2021. And since more than 60 per cent of Swiss imports come from eurozone countries, the unintended overvaluation of the Swiss franc relative to the euro had a welcome consequence: it softened the increase in import prices, reducing the imported component of Switzerland’s inflation.
But the failure to bring the value of the franc down to the target also compelled the SNB to complement its policy of negative interest rates with direct foreign exchange market intervention. Indeed, to prevent the further appreciation of the franc, the SNB purchased large quantities of foreign currency in the exchange market, accumulating reserves totalling 1,044.8 billion francs by May 2022.
Nonetheless, although still relatively low, Switzerland’s inflation started to rise rapidly this year, rising above the 2.0 per cent target in February and above 3.0 per cent in June. The SNB’s priority now switched from trying to prevent the increase in the value of the franc to trying to reduce inflation. To that end, the SNB increased the policy rate by 50 basis points in June and by an additional 75 basis points in September, thus ending the era of negative interest rates. In addition, not only did the SNB stop purchasing foreign currency in June, but it also became a net seller of foreign currency in the exchange market. Consequently, its reserves of foreign currency decreased to 807.1 billion francs in September from more than one trillion in May. As a result, the Swiss franc has appreciated by almost eight per cent with respect to the euro since June 2022, further contributing to reducing the imported component of Switzerland’s inflation.
What can Canada learn from Switzerland’s experience?
Firstly, that the mandate of a central bank should not be limited to maintaining price stability. Rather, the rate of interest should be used as an instrument to achieve different objectives depending on the specific circumstances of the moment. In Switzerland’s case, the priority until June 2022 was to prevent the overvaluation of the Swiss franc, and since then the priority has become to reduce the rate of inflation.
Secondly, central banks should intervene in foreign exchange market to prevent the overvaluation of the domestic currency and the loss of competitiveness of the country’s exports. The rate of interest and the exchange rate are arguably the two most important prices in the economy, and thus neither should be left to the market to determine.
And thirdly, the credibility of the central bank is important, but not as important as the confidence in the central bank. The credibility rests on always implementing what is expected — for instance, always increasing the rate of interest when inflation is above the target. But confidence in the central bank implies expecting the bank will exert flexibility and do whatever is best for the economy and society.
As former Italian PM Mario Draghi famously stated when he was president of the European Central Bank and the future of the euro was at stake: the bank will do “whatever it takes.”
