The Strategist

Swiss precision: fine-tuning monetary policy to economic conditions and the Swiss franc

25 or 50 basis points is the critical question on the mind of Martin Schlegel, the new president of the Swiss National Bank (SNB). The fact that another SNB rate cut is coming on 12 December is a near certainty: the Swiss economy is growing at a sluggish but stable pace, unemployment is rising gradually but remains low, and annual price pressures are hovering near the midpoint of the SNB’s 0% to 2% target band. This economic backdrop argues in favour of a gradual 25 basis point cut.

Date: 10 December 2024
Author: Tina Jessop, Senior Economist, LGT Private Banking
Reading time: 10 minutes

However, monetary policy considerations take on a different dynamic when you are a small, open economy with a flexible currency that is globally recognised as a haven of safety.

Complex dynamics: trade openness and safe-haven status

Switzerland’s share of the global economy is 0.8%, yet its exports make up 2% of all goods and services traded internationally. Total trade - exports and imports of goods and services combined - accounts for a massive 140% of Swiss GDP. 0.2% of the world’s currency reserves are held in Swiss francs. This may sound modest in absolute terms, but it is a remarkable position, reflecting the country’s strong financial sector, political and regulatory stability and its stable economy, with government debt-to-GDP below 40%, a rare-to-come-by fiscal surplus and a current account surplus.

These attributes have catapulted the Swiss franc into lofty territory and point to further strength ahead, perhaps even amplified by geopolitical and trade policy uncertainty as investors seek safe havens. Switzerland’s high import share - imports account for a quarter of the consumer basket - means that a strong Swiss franc could translate into deflationary pressures at the same time as exports weaken due to loss of competitiveness. Lower exports, in turn, mean lower capacity utilisation and thus, lower inflation. As a result, maintaining price stability in the context of the strong Swiss franc is challenging.

Swiss franc: pillar of strength and a headache for the SNB

Following the Global Financial Crisis (GFC), the SNB had to resort extensively to unconventional monetary policy tools to ward off Swiss franc appreciation. Foreign currency reserves increased dramatically from CHF 50 billion in 2007 to a peak of almost CHF 1 trillion at the end of 2021. The key monetary policy rate was held at -0.75% for more than seven years before the Covid-induced inflation surge drove up central bank rates in 2022. Since then, cooling inflation and below-trend growth have allowed the SNB to reduce the policy rate from 1.75% in early 2024 to 1.0% today. At the same time, currency intervention has given way to interest rates as the main policy tool.

Swiss economic outlook: steady as she goes

In the current environment, we believe that a series of smaller cuts with a certain degree of flexibility are the right amount of Swiss precision at this stage. The Swiss economy is holding up relatively well, with 1.5% real GDP growth in 2024, a growth momentum that we expect to resume in 2025. Consumer confidence is still low, but the solid labour market and real wage growth should support consumption going forward. Industrial production remains mixed, but it has shown some positive momentum recently, driven by a strong pharmaceuticals sector that masks the weakness in machinery and auto-related sectors, which in turn reflect the ongoing manufacturing recession in Germany. Despite the strong Swiss franc, capacity utilisation has seen an uptick in Q3 2024.

Export weakness is the predominant downside risk for 2025. Trade policy uncertainty stemming from the incoming Trump administration in the US, as well as the bleak outlook for German industry, could weigh on Swiss manufacturing. However, we also see reasons for optimism: the ECB is well into its rate-cutting cycle, and German elections and Chinese stimulus could revive sentiment. For now, we view the risks to our economic outlook as balanced.

Inflation in the lower half of the SNB’s target band

The headline consumer price index (CPI) came in at 0.7% yoy in November, below the midpoint of the 0% to 2% SNB target range. Excluding energy and food, the core CPI stands at 0.9% yoy. Both have increased mildly from the previous month, but are still well below the peak levels seen in 2022.

Falling energy prices and the strong Swiss franc have been the main reasons for the recent rapid deceleration in inflation. In November, the price of imported goods fell by -2.7% yoy, while domestic goods and the prices for services increased by 1.7% and 1.8% yoy, respectively. The Swiss franc is trading at a near all-time high against the EUR, and while it remains strong against the USD on a long-term basis, it has given up gains against the greenback in recent weeks. We expect the drag from imported inflation to resume, but to cool based on recent dynamics and our 2025 outlook for the key currency pairs. Domestic inflation should continue its slow retreat. We therefore expect CPI inflation to remain in the 0.5 to 1% range for the next year.

Higher likelihood for gradual easing and verbal support

In line with the moderate growth and inflation outlook, we expect the SNB to make three further cuts of 25 basis points from the current level of 1%. We expect one 25 basis points cut on 12 December 2024, one in March 2025, and one final cut in June 2025. This translates into a terminal SNB rate of 0.25% by mid-2025, and implies that monetary policy conditions will turn to neutral or expansionary after the December rate cut.

In order to avoid further strengthening of the Swiss franc and thus deflationary pressures, we expect the SNB to be vocal in emphasising its determination to maintain price stability, also in the form of currency interventions and negative interest rates, if deemed necessary. Given the importance of interest rate differentials for the exchange rate, deeper and faster SNB rate cuts could materialise if the ECB accelerates its rate-cutting path on the back of weaker growth.

Looking ahead: the impact of US trade policy on economic growth and monetary policy

The US is the largest export market for Swiss goods. Goods exports to the US account for around 15% of total Swiss goods exports and 6% of Swiss GDP. As a result, Switzerland runs a large trade surplus with the US, a feature that could bring Switzerland into the focus of the incoming Trump administration.

Any weakening in the external environment would impact Swiss exports and weigh on growth. 45% of Swiss goods exports to the US are pharmaceutical products, including vaccines and medicines. Many of these goods have a low price elasticity of demand, meaning that tariffs on Swiss imports to the US can likely be passed on to end consumers without a material loss in demand. The direct impact of tariffs is therefore likely to be relatively modest, despite Switzerland’s openness to trade. Indirect effects will also come into play, including through trade exposure to Germany and a general reluctance to invest in times of uncertainty. A study by the KOF institute at ETH Zurich estimates that Trump’s tariffs could reduce Swiss GDP by 0.2%. In the case of a larger trade war, where companies relocate production to the US, the impact could be up to one percentage point over time.

Notably, Switzerland was labelled a currency manipulator by the first Trump administration in 2020. The large trade surplus with the US coincided with the large increase in the SNB’s balance sheet resulting from FX intervention. Should the SNB deem an artificial weakening of the Swiss franc necessary through FX intervention, the risk of US import tariffs on Swiss goods could increase. These considerations will clearly factor into the SNB’s decision making, increasing the need for Swiss precision.

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AAA/Aaa: Borrower with highest credit quality. Default risk also virtually negligible over the longer term
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