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Key interest rate increase in Switzerland - How Central Banks fight inflation

Updated on July 04, 2022

Electricity prices will rise by 20 percent or more in 2023 - more than half of all energy suppliers expect this development. The reasons for this are, on the one hand, higher fuel and CO2 prices and power plant outages and shutdowns. On the other hand, this already tense situation will be exacerbated by supply bottlenecks and the war in Ukraine. In response to these inflationary pressures, both the European and the Swiss National Bank have been repeatedly asked to raise interest rates. The SNB has now also yielded to this pressure: The inflation rate of 2.9% prompted the SNB to raise the key interest rate from -0.75% to -0.25% in June 2022.

What are the implications of this rate hike and how is it intended to mitigate inflation? Learn more about the Swiss National Bank's monetary policy and how the key interest rate hike will impact nationally and internationally in this article.

Monetary Policy of the Swiss National Bank

Because relative monetary policy has a significant impact on the EUR/CHF exchange rate, the Swiss National Bank bases its monetary policy on the European Central Bank ECB. Economists consider this exchange rate to be the most important instrument for influencing the Swiss economy. In response to the financial crises of 2008, interest rates fell to record lows even then in order to save the banking sector and prevent an economic depression. Since the Swiss franc is regularly used as a refuge currency in times of crisis, the SNB had to set the key interest rate below 0. This prevented the Swiss franc from appreciating further against other major currencies. The negative interest rate was intended to encourage people to invest the available capital in the economy instead of saving.

Effects of Monetary Policy Decisions on the Economy

The central bank or National Bank determines the interest rates at which commercial banks can borrow money or deposit it. It thus interacts only with the banks. It is important to note that the outcome of monetary policy also depends on these banks, and that monetary policy always has a lagged effect. This is because it does not directly change the prices in the stores, but only the conditions vis-à-vis the banks, which in turn adjust their conditions when issuing loans and depositing money.

Increase in the key interest rate - effects

So what are the effects of a key interest rate hike on the real economy?

1. Higher interest rates: no bank would accept lower interest rates than it has to pay for drawing money from the SNB. So if the SNB raises its key interest rate, loans will become more expensive. As a result, both companies and private individuals will want to take out fewer loans, and as a result of the drop in investment, overall economic demand will also fall.

2. Saving becomes more attractive: The higher key interest rate also leads to higher interest rates on bank balances. Therefore, it becomes more attractive to deposit money in accounts instead of investing.

3. Appreciation of the Swiss franc: the interest rate hike also makes it more attractive for investors from abroad to invest their money in Switzerland again. If they sell their currency to invest the money in Swiss francs, the exchange rate will rise.

4. Imports, exports and price levels: Because the Swiss franc becomes more expensive for foreigners, the prices of Swiss products abroad also rise, which reduces foreign sales and thus exports. At the same time, however, import prices are also falling, as foreign goods have become cheaper in relative terms. This leads to a decline in demand for domestic products and increased imports. As a result of falling import prices and reduced domestic demand, the prices of domestic goods also fall so that they can still be sold.

5. Falling asset values: Higher interest rates mean that future cash flows, such as dividends, are worth less. As a result, the value of assets also declines. This makes their owners feel poorer and consume less, which also leads to reduced aggregate demand.

6. Decline in creditworthiness: Due to the decline in the value of assets, real estate, which is used as collateral for loans, is also worth less. Borrowers therefore also have higher debts due to the higher interest rates, which can make follow-up financing more difficult. This also leads to a higher probability of default. In addition, rising interest rates and higher required collateral generally make fewer potential borrowers creditworthy. Both effects mean that fewer loans are granted and demand falls.

Lower demand and lower prices

The effects triggered by a key interest rate hike are manifold and ultimately lead to reduced demand. This leads both directly and indirectly to lower prices:

On the one hand, directly: Due to the lower demand, fewer people buy, which is why companies have to lower their prices in order to still be able to get rid of products.

On the other hand, indirectly: because of the drop in demand and consumption, fewer workers are also needed. This also has an impact on wages: Employees have weaker negotiating positions and can therefore demand lower wages or even fear for their jobs. This lowers the labor costs of companies, which in turn can offer their products at lower prices. And due to the lower wages, demand also decreases. 

 

In summary, an increase in the key interest rate has the effect of reducing overall demand, slowing wage growth and worsening the outlook for the labor market. At the same time, however, it also leads to a stabilization of the value of money, falling prices and flattens the inflation rate.

Oliver Diggelmann

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